LexisNexis(TM) Academic - Document

LexisNexis(TM) Academic - Document
Copyright 2005 The Financial Times Limited
Financial Times (London, England)

July 27, 2005 Wednesday

SECTION: FT REPORT - INDIAN BANKING & FINANCE; Pg. 22

LENGTH: 1127 words

HEADLINE: Reform of banks is a priority There has been liberalisation but much remains to be done, writes Jo Johnson

BYLINE: By JO JOHNSON

DATELINE: NEW DELHI

BODY:


At recent celebrations marking the 200th anniversary of the State Bank of India, the country's largest bank, Prime Minister Manmohan Singh could not resist the opportunity to boast about the country's banking system. "If there is one aspect in which we can confidently assert that India is ahead of China, that is in the robustness and soundness of our banking system," he said.

The banking system may not be suffering China's bad loans problem, but few economists believe its performance is a cause for celebration. There is ample evidence to show that, despite reforms launched in 1991, an inefficient financial sector remains a significant obstacle to government hopes of achieving the 8 per cent rate of economic growth it believes can lift hundreds of millions out of poverty.

India has managed to achieve an impressive rate of savings, with the World Bank estimating a share of financial assets in GDP of 173 per cent, compared with 104 per cent in Mexico, 112 per cent in Indonesia and 157 per cent in Brazil*. But this is only patchily invested in the real economy because of government funding requirements. Government inability to manage its finances is at the heart of the banking system's weakness as a financial intermediary. High deficit financing requirements - state and central budget deficits combined are 10 per cent of GDP - crowd out credit to the private sector. More than 40 per cent of the banking system's resources are invested in government securities.

"The government is absorbing such a large part of bank deposits for funding its revenue expenses and subsidies rather than long-term investments - that there's not enough left on the table for banks to explore lending opportunities beyond the large corporates," says Chetan Ahya, an economist at JM Morgan Stanley. "That's the whole problem with economic growth in India. It's skewed towards the people at the higher end."

Economists are alarmed that banks hold far more in government securities than required by the statutory liquidity ratio. This has been lowered from a peak of 38.5 per cent of net demand and time liabilities in February 1992 to 25 per cent.

Large segments of the economy remain excluded from access to formal finance. The ratio of private credit to GDP remains low at less than 40 per cent, compared with more than 100 per cent for countries such as China, Malaysia and South Korea. Moneylenders have a tight grip over the 70 per cent of India's rural poor with no bank account.

"There's something going wrong here," says Priya Basu, lead sector specialist at the World Bank. "There's pressure on the banks to invest much more in government securities than the statutory liquidity ratio requires. Given that the banks are then obliged to lend 40 per cent of net deposits to priority sectors, there's scarcely a quarter left for bank managers to lend as they see fit."

Poor contract enforcement, lack of credit information and weak bankruptcy laws accentuate the innate risk aversion of public sector bank managers.

For much of India's post-war history, central planners used the banking network to channel savings towards political priorities. Many banks were nationalised; credit was directed to sectors on the basis of quantitative targets and subsidised interest rates; and rural networks were built in accordance with social objectives without regard for profitability.

Over the past decade and a half, that has started to change. Interest rates have been largely liberalised, banks' required holdings of government debt reduced and obligations to lend to priority areas such as agriculture and small-scale businesses relaxed. These reforms encouraged deposit growth, the development of a credit culture and entry of private and foreign forces.

The feat of combining liberalisation and stability, overseen by the Reserve Bank of India, should not be underestimated. The RBI's conservative approach to reform was vindicated during the east Asian crises of the late 1990s. The contagious panic that spread across Thailand, Indonesia, Malaysia and South Korea left India's largely state-controlled financial sector unscathed.

"India's banking system appears to be sheltered from a crisis because (the country's) exchange rate regime is flexible, foreign exchange reserves are high, the capital account is not yet fully convertible and banks and their customers have limited, albeit growing, foreign exchange exposure," the World Bank sector specialist argues in a recently published essay.

Despite the success of new privately-owned Indian banks, such as ICICI and HFDC Bank, and the efforts of foreign banks such as Citibank, Standard Chartered and HSBC to make inroads, the country's financial landscape remains dominated by lumbering public sector institutions whose fragility and inability to liberalise has slowed reform.

The Reserve Bank of India's concern over the systemic risks involved in exposing underperforming public banks to the full blast of competition is the principal cause of the country's slow-motion liberalisation. In February, the RBI released an ultra-cautious roadmap for the sector, putting a brake on foreign takeover of banks until 2009.

"If I had to sum it up in one sentence, I'd say the banking system has traded efficiency for stability," says Ms Basu. "India's financial system is not about to collapse and if the government really wants the economy to grow at a faster pace, the time has come to focus on banking sector efficiency."

The public sector banks, which control more than 52 per cent of financial assets, retain powerful positions. They have extensive branch networks and enjoy the explicit guarantee of central government, a significant confidence boost for depositors in a country whose households, according to Morgan Stanley, were in March 2005 hoarding Dollars 200bn of gold, 2.5 times their holdings in the stock market.

So far, private and foreign banks, with much smaller networks, have made little inroad into the business of mobilising savings and demand deposits from the public, a business dominated by the public banks. Their arrival has been felt most in the high grade corporate market, where spreads have come down with growing access to capital markets and offshore finance.

A second wave of reforms forcing greater efficiencies on the banking sector is long overdue. "Many of the proposed reforms challenge the interests of privileged groups and some could involve painful adjustment, but delay will only increase the costs further," writes Michael Carter, head of the World Bank in India. "Financial sector reforms are critical to achieving sustained growth and prosperity."

*For further reading, see India's Financial Sector: Recent Reforms, Future Challenges edited by Priya Basu, Macmillan India, 2005, pp224, R350

LOAD-DATE: July 27, 2005