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September - 2008 - issue > In My Opinion
The need for reforms
Raghuram G. Rajan
Monday, September 1, 2008
Today, there is not only tremendous capacity for growth directly in the financial sector, but also that the financial sector itself could contribute to the growth process by allocating resources better and by managing it better. So both directly and indirectly there could be tremendous growth. The kinds of jobs that are available in financial sector are high value-added jobs and these could be very beneficial for the young generations that are coming out, including many from this place. However there are weaknesses in the financial sector and this could hinder the long-term objectives of growth, inclusion and stability, and this is why we need reforms.

Now why reforms are important?
One reason is greater inclusion and by inclusion we must remember that we are not just talking about the poor. The median Indian household is actually an excluded household from many perspectives. It does not get access to several financial services. One statistics that I find specifically interesting is despite the focus on credit, the whole nationalization process was an attempt to send credit to the sections that had been missed out. The most recent survey of financial habits of households suggests that a median household borrows 75 percent from informal sources, and only 12 percent of its borrowing is from formal sources. This is appalling. It suggests that actually a median household does not really have any access to financial services. This is for credit and it is also true for the saving accounts. Despite the RBI’s attempt to get universal savings account, and there has been a lot of talk, action is going on but too little. At this rate, even if we increase two to three million accounts a year, to get accounts to every household will take 25 to 50 years and that is too long for people to wait. So there is a problem, despite the change, despite the growth and that problem needs to be remedied.

The second big problem is that the public sector banking system is falling behind – not today, not in terms of profitability, but from a longer-term perspective, from the perspective of the future. They don’t have the clients that the private sector banks have, they don’t have the staff and the skills that the private sector banks have, they don’t have the automation and the low cost increasingly in reaching the customers that the private banks have, and finally they don’t have the capital to meet the needs simply because the government is not willing to let go. The government has to be a part of the capital raising process if the banks have to have capital. So they are serving as a drag and they are serving as a drag for two reasons—one they will increasingly become less and less efficient unless these constraints on them are remedied, and second because the Reserve Bank fears that these public sectors bank will prove unequal to competition. So it restricts competition in a variety of ways. It restricts the kinds of activities that banks can get into, not only in public sector but also in private sector in order to stabilize the system. This kind of two-way drag is going to be problematic in future and we need to think about how to remedy it.

Third, the infrastructure financing needs are enormous. The financial institutions are relatively small and the markets don’t have depths to finance the needs, which are going to come on board. Five to six hundred billion, and lot of financing needed! We need depth, not just in equity market but in corporate bond markets which are completely missing at this point.

Fourth, the international forces are buffeting the country. We saw the rupee appreciate a considerable amount last year and we saw it depreciate a considerable amount this year. Our macro economy is being buffeted by international forces and we need to ask if we have a macro-economic framework which can actually cope with these forces. Unfortunately in my view, our macro-economic framework has not adapted enough to take into account these new sources of concern. So now we can take these issues a little bit more in detail and talk about the kinds of reforms one might propose.

The first issue that I put on the table was the finance of the masses and it is not just about credit. It is about savings, payments, insurance, investments and pensions and you could think of the savings account as being a gateway to get everything else. Start with savings, see savings behavior, get information in that process, and understand how people use their money and then go on to credit and other financial services. The idea of government transfers directly to the saving account is actually more powerful than just about financial reforms. It is a way of giving subsidies directly to the household and that is something we need to think about more and more over time. Think for example, the current petroleum subsidies, which are costing the country enormously and which are so poorly targeted because after all who uses the most petrol isn’t the poorest of poor but it is the middle class and the upper middle class households that drive cars. So in that sense that subsidy is terribly targeted. If you were really worried about the high cost of energy, you would target the subsidy much more carefully by a direct income transfer to the poorest households. I am not necessarily saying that it is needed, but that would be a much better way of sending the subsidy than through subsidizing petrol.

Similarly this loan waiver – I was actually taken a little taken aback by the reaction in the previous panel – the loan waiver is a disaster! It is a disaster because it spoils the credit culture completely and the notion that the loan waiver would be further rewarded by a fresh loan seems to me appalling in terms of destroying the credit culture. There could be far more effective ways of doing it. Perhaps we are not equipped to do it now but we must recognize that this is not the way to go in the future. Again loan waivers are poorly directed, but it is not the direction which is the problem, it is the fact that we spent fifteen years in getting away from the loan waivers and actually building up a credit culture and now you have vitiated that entirely by making this massive loan waiver. Semitics is important and it is a waiver, it maybe over the due loans but it is a waiver! And let’s not forget that. A better way of doing that might have been that if you really think that there are poor households who are on the margin and over-indebted, you could have found a way to either directly make transfers to those households or to get some form of renegotiation of specific debts between the banks and individuals on the basis of ability to pay rather than a blanket hit waiver which essentially rewards those who are falling behind and penalizes those who are making an attempt to stay on payment.

Another issue, which I think would be very important in inclusion is to roll out a National ID. Once you have a National ID which allows the formation of a credit history and a credit record and your being timely in your payments in your past loans, will allow you access to the future credit. So your credit history is in some sense collateral for future borrowing, which is what you put at stake and that could be a very useful thing in improving the credit process. So I think National ID is long overdue and I am very glad that this present government is actively pursuing the process of bringing it out. Credit information can be very valuable when it is attached to a national id but the problem right now is the way the credit information is shared. It is shared within a narrow circle of financial institutions. That means that anybody who does not borrow from one of the institutions who are the part of this process essentially gets excluded and too many people don’t borrow from formal financial process and therefore so many people are excluded! It would be more useful if we could bring in more information into the credit information system, information from say the macro-financial institutions, information from local area banks, from credit co-operatives and from non-financial sources. The single biggest source of information about payments is the cell phone companies because so many people have cell phones. If that could be incorporated into the credit information system and similarly information about rent, utility payments, water bills and if all this could be incorporated, you will have a wealth of information on which to make credit decisions. So sharing information, I think, is extremely important.

Lastly one of the biggest sources of collateral for people in this country is land. Unfortunately proper title to the land is hard to come by, so what we need on an expedited basis is land registry, land titling and that is something, which is extremely important because that would then give people source of collateral against which to borrow. Land registry and land titling are clearing that mess up, and it is truly a mess, and it is extremely important in this country.

The author is Eric J. Gleacher Distinguished Service Professor of Finance, Graduate School of Business, University of Chicago.
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