Capital flows into India have to be consistent with macroeconomic stability and financial stability
The growth of the corporate bond market has been disappointing and it has not performed the expected role of financing infrastructure as well as it should
The priority is to protect the principal of savers even if it means relatively lower returns to them
India’s financial system, by design, leans towards caution. This bias towards stability, even at the cost of greater innovation, will persist in the foreseeable future, according to TT Ram Mohan, part-time member of Economic Advisory Council to the Prime Minister and former professor of finance and economics at IIM Ahmedabad.
"At the present per capita level of the Indian economy, a certain risk-aversion is inevitable," says Ram Mohan, who has been associated with many committees with financial institutions including the Reserve Bank of India (RBI).
In an exclusive interview with Outlook Business, the economist shared his insights on India’s financial system, examining its home-grown approach, the balance between stability and economic growth, and the challenges it faces in meeting the country’s long-term development goals. Edited Excerpts:
India is about to surpass Japan. If it wants to eventually match the scale of the US and China, what would that take financially, both in terms of institutions and capital flows?
The financial system has to scale up to meet the growth of the economy. That has been happening in every way over the years. The banking sector, stock market, mutual fund industry, and insurance sector have all shown growth with increasing technological sophistication. The improvement in the payments architecture, in particular, has been dramatic.
Capital flows, whether FII (foreign institutional investor) or FDI (foreign direct investment), have also grown substantially. Capital flows are the flip side of the current account deficit. If we assume a comfortable current account deficit of 2% of GDP then that is also the size of capital flows the economy can digest. This is something that is forgotten by those who continuously clamour for more flows. More is not necessarily better. Capital flows into the country have to be consistent with macroeconomic stability and financial stability.
There are elements in the financial system, such as venture capital, private equity, distress asset funds, et cetera, which are still in their nascent stages. The growth of the corporate bond market has been disappointing and it has not performed the expected role of financing infrastructure as well as it should. There are structural issues for that, such as the dominance of government securities and the statutory liquidity requirements for banks. It is unlikely that those constraints will get mitigated in a hurry.
What we need to focus on, perhaps, is the development of the human resources required for the financial sector in the years to come. The government, regulators, financial market players and leading educational institutions need to come together to formulate a systemic plan for building the necessary skills and capabilities in large numbers.
Do you think ratings by global credit rating agencies constrain significant capital flow and are a concern for the funding required for India's economic expansion?
It is well documented that the ratings given by the international agencies are not consistent with our macro-economic risk profile. The low ratings may not constrain the volume of capital but they certainly result in higher cost than would be the case otherwise.
When we look at the US and China, how did their financial systems evolve to support long-term industrial growth and economic expansion? What can India learn from them?
The US financial system is often described as capital market-driven, while China’s is predominantly bank-led. But one has to understand that in the US, the banking system too is very large in relation to GDP. Any healthy financial sector has to have a combination of banks and financial markets to support economic growth. The American banking system is dominated by private sector. In China, public sector banks dominate and to a greater extent than that in India.
What do we learn from the US and China? Well, financial systems do have a crucial role to play in supporting economic growth. But the creation of vital physical infrastructure and human resources happens primarily though the state in the initial stages. It is only after the state has put in place the basic infrastructure that the private sector comes in. There is no escape from substantial state funding to start with.
We have learnt in recent years how some of the great innovations in the US, such as the internet, arose from state funding of research. We read now about the present US administration’s move to rein in the leading private universities by curtailing state funding. These are private universities with huge endowments and yet even at Harvard, around 10% of the annual budgetary spending comes from the state! That is a point that cannot be over-emphasised.
In terms of the business model, when it comes to banking, both China and India accord a key role for public sector banks and a much lesser role for foreign banks. Domestic private banks have a significant role in India. The key concerns in limiting foreign bank presence are regulation and supervision of foreign banks, the potential for instability with significant foreign bank presence and larger objectives such as financial inclusion.
We have learnt and built from our own experience, instead of trying to imitate the US or China. And that is all to the good. That is also true of India’s capital markets. It cannot be contended today that we have lost out in technological sophistication so far as the market infrastructure is concerned.
What is material is not just growth in the size of the financial sector but the ability of regulation and supervision to keep pace with growth. This is where India has scored, particularly in banking. It would not be an exaggeration to say that regulation and supervision of banks in India is superior to that in many developed countries. The learning is that home-grown solutions based on the ground realities obtaining here are superior to importing solutions from elsewhere.
In that case, any reform priorities you suggest?
We need a financial system that is adequate for the expanding needs of the Indian economy. It is not clear that there must be an attempt to reshape the financial architecture in a particular way. It has to be allowed to evolve in its own way in response to the requirements of the economy.
What is essential is that the pre-conditions for a healthy financial system are met. From that standpoint, the first reform priority would be minimising regulatory arbitrage among various financial institutions, whether regulated by the RBI or SEBI. Second would be better governance of bank boards, including improved compensation for independent directors at public sector banks. Third is a comprehensive plan for training in modern risk management at all levels starting from the top management of financial institutions.
Many argue that India’s banking-led financial system has not delivered the capital needed for industrialisation or job creation. Where did we structurally fall short?
It would not be correct to fault the financial system for industrialisation and job creation falling short. Today, banks are ready to lend but there are not enough takers for long-term finance. In the past too, lack of finance has not been the main reason for the manufacturing not taking off. One reason often cited is the unwillingness of small firms to scale up and become competitive because of labour laws that do not allow adequately for firms to shed workers when not required. Even that may not be the primary reason.
Inadequate R&D (research and development) and lack of innovative or cost-competitive products, the emergence of manufacturing in a big way in East Asia and then China, are all factors. The failure to practice industrial policy, which is being attempted now through measures such as the PLI (production-linked incentive) scheme, contributed to this. That said, access to credit for MSMEs (micro, small and medium enterprises) has indeed been an issue. That is now beginning to get addressed with greater formalisation of MSMEs and availability of better financial information on these.
As you pointed out that the growth of the corporate bond market has been disappointing, what systemic reforms India should consider to have depth in long-term credit markets to support economic growth?
Numerous committees have gone into this issue and made recommendations and this is not the place to get into details on those. The high cost of funds, in the absence of risk mitigants such as first loss buffers or guarantees, has been cited as a reason for firms’ unwillingness to use these to finance projects. Then, private issuers have to compete for funds with public sector firms that have an implicit government guarantee and hence are preferred by investors.
There is lack of liquidity given the absence of well-capitalised financial intermediaries in the bond market. Large domestic institutional investors are constrained by requirements not to go below highly rated bonds. We had developed an alternative to the bond market, namely, term finance institutions but these have fallen by the wayside. It does appear that the decision to convert financial institutions into banks was not well thought through.
Today, the task of financing long-term projects has devolved substantially on the banks. The challenge for banks traditionally has been the asset-liability mismatch, which is using relatively short-term funds for long-term investment. Banks today are in a better position to finance long-term projects, given the availability of derivatives to hedge risks. However, not all banks may have the expertise required for such financing. A secondary market for loans has also developed with some banks taking the risk up to the construction stage and then selling the loans to other banks.
With rising fintech, NBFCs, and private credit, how can India strike the right balance between financial innovation and systemic stability? Is our regulatory architecture future-ready?
There has been and there will be, in the foreseeable future, a bias towards systemic stability at the expense of greater innovation. At the present per capita level of the Indian economy, a certain risk-aversion is inevitable. The priority is to protect the principal of savers even if it means relatively lower returns to them.
The RBI takes a unified approach to regulation that covers commercial banks, NBFCs and cooperative banks. Fintech has thus so far been lightly regulated. Where institutions, such as NBFCs, become systemically important, they come in for stringent regulation. The RBI also favours converting themselves into banks when they have grown beyond a certain size so that they come in for more stringent regulation. From the point of view of systemic stability, the issue always is bank exposure to other entities, such as NBFCs and fintech. The RBI does not hesitate to clampdown where the exposure is too large for comfort or growing too fast.
The regulatory structure is an ever-evolving thing. It evolves along with the growth of existing players and emerging players. Is the regulatory architecture equal to today’s demands? Yes. Do we have an architecture that is ready for the times to come? Well, that does seem a big ask.
