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The Promises Of Raghuram Rajan


Dr. Raghuram Rajan takes his stand as the Governor of the Reserve Bank of India. Generous praise has been showered upon him already, making him look like James Bond and all that. Which is good, in terms of confidence in an RBI governor, but it might be a little premature. Here’s what I read in his speech:

The RBI should have stable objectives.

Rajan says that it should be very clear what the focus of the RBI should be. I have written in the past (Cut up the RBI) that the RBI does too many things, and sometimes it finds itself in compromising and conflicting situations. It has to raise interest rates to combat inflation, but raise it too much and then it can’t sell government bonds for which it is the merchant banker. It has to control currency movements, but manage monetary growth (or constriction). It has to be a bank regulator, but also the lender of last resort.

Rajan says:

let me emphasize that the RBI takes its mandate from the RBI Act of 1934, which says the Reserve Bank for India was constituted

“to regulate the issue of Bank notes and the keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage;”

The primary role of the central bank, as the Act suggests, is monetary stability, that is, to sustain confidence in the value of the country’s money. Ultimately, this means low and stable expectations of inflation, whether that inflation stems from domestic sources or from changes in the value of the currency, from supply constraints or demand pressures.

This immediately tells you: He will not be averse to raising rates to curb inflation, and he will take steps to stabilize exchange rates.

The other two objectives mentioned are: Inclusive Growth and Financial Stability.

More Banks, Freedom in Branch Expansion

In very welcome news, Banks have been freed from onerous branch presence requirements. For every urban branch to be opened, a bank had to have multiple rural ones, and there were a number of requirements for each new branch. Foreign banks that had more than a certain number of branches had to necessarily cut branch count or have other priority sector requirements (most chose to cut).

Now, Branches can be opened at will, without permission. But there are caveats.

We will, of course, require banks to fulfil certain inclusion criteria in underserved areas in proportion to their expansion in urban areas, and we will restrain improperly managed banks from expanding until they convince supervisors of their stability.

We will need more clarity but on the whole this is great for banks, and this is even better for the new banks that come in.

Dr. Bimal Jalan, a past governor (and a very good one at that), will oversee a committee that looks at new bank licenses, which then get suggested to the RBI board, and licenses may come by January 2014.

Rajan also wants bank licenses on tap, as has been suggested in a recent RBI document that I have overlooked. This is a great idea. I come from a banking family so I may be biased, but it will be great to have many more banks in the country.

Foreign banks that currently operate as branches of foreign banks will be “nudged” to move to a subsidiary structure so they can be better regulated.

Remove Lazy Banking By Lowering SLR, Changing Priority Sector Requirements

With 23% of all deposits going to government securities, and then 40% of other lending as priority-sector-only, lending has become lazy.

Rajan plans to cut SLR – the Statutory Liquidity Ratio – which otherwise ensured a steady demand for g-secs. Not immediately, but over time. Hard to see this happen unless the fiscal damage is contained.

(Note that the government will borrows nearly 50% of all new money created in this coming year. The demand has to increase, not decrease, and I don’t know how the RBI will actually sell securities. Already auctions are devolving faster than ever)

Priority sector lending is a waste of time, honestly. It should be like 10%, if at all. It hampers new lending and makes the richer people even richer because they can find ways to qualify. Lending to rural areas, housing loans, lending to microfinance companies – all these qualify as priority sector. These get a lower risk weight, but that is a horrible way to do it – some of these are necessarily higher risk!

Some of these people are happy to get money at higher rates, because their alternatives are to borrow from moneylenders at even higher rates. We should move off the priority sector bandwagon. My view. Mr. Rajan might agree, but he’s appointed a committee to come back with suggestions.

Likely To Remove Bans and Curbs on Currency Trading

Rajan says:

Too many risks in the Indian economy gravitate towards commercial banks even when they should be absorbed by arm’s length financial markets. But for our financial markets to play their necessary roles of providing risk absorbing long term finance, and of generating information about investment opportunities, they have to have depth. We cannot create depth by banning position taking, or mandating trading based only on well-defined “legitimate” needs. Money is fungible so such bans get subverted, but at some level, all investment is an act of faith and of risk taking. Better that investors take positions domestically and provide depth and profits to our economy than they take our markets to foreign shores.

This is great news. Currency trading limits and bans should be removed. We are being silly, and I’ve noted this with great consternation in the past.

Position limits should be based on the size of the market, nothing else.

Exporters and Importers can now re-book cancelled forex contracts to the extent of 50% of the value of earlier cancelled contracts. (Earlier, importers weren’t allowed rebooking and exporters could only do 25%)

Impact: Well, great for importers and nice for exporters. Now they can hedge at ease. But the 50% limit still irks me – why not the whole amount?

Back to Interest Rate Futures

There will be a cash settled interest rate future scheduled. The last one on the NSE didn’t do very well, and it was based on the US future. We need better ideas.

Will Free The Rupee

This section has the biggest impact, in my opinion. I’ve already written about the special swaps that RBI is providing banks to cut their hedging costs.

But Rajan talks of a greater deal. To actually free the rupee.

As our trade expands, we will push for more settlement in rupees. This will also mean that we will have to open up our financial markets more for those who receive rupees to invest it back in. We intend to continue the path of steady liberalisation.

I can’t help say this again: I’ve always wanted to free the rupee.

Financial Payment System Changes

A huge change is in the offing for payments.

A bill payment system for large corporates will come in (Electronic Bill Factoring Exchanges). The idea here is when a large company order is paid for, the payment can take a long time (three months to a year of payment terms). Someone may be willing to pay the
bill amount (minus a discount) upfront, while they wait to collect from the large company. If the production and acceptance of a bill is electronic, then the risk is simply like the risk of default of the large corporate; it helps the small businesses get paid promptly for a discount, while others can hold the bill as if it were a debt security.

There will also be a new Giro-based account-to-account payment system to pay utilities, school bills etc. Giro is simply any money transfer initiated by the payer (like a cheque, an NEFT transfer etc.). As an exchange, it could simply mean an extension of the NEFT system but with billing – so I can say this person needs to pay me X, and list my bank account, and then that person can come on to the platform and pay me X by doing an NEFT online. The important difference is: I will know who paid for what bill, which the current NEFT system is terribly deficient in. (I hope it works this way. Otherwise it’s just the NEFT.)

To come: Pre-paid instruments may be converted to cash in certain cases where there is aadhaar identification. If this happens, it is absolutely huge, but will require reporting to tax authorities (because it can be used for money laundering)

There’s also a committee for improving mobile-based payments,

Going Hard on Defaults

Rajan will be tough on defaulters. He says there is no divine right for promoters to stay on board if they mismanage their companies, or for them to use the banking system as an exit route. This will not bode well for large corporates, especially those that have been “restructured”.

Banks will be forced to clean up their balance sheets, and take the hits on bad loans. This again is going to be tough for public sector banks.

CPI Inflation Indexed Certificates

As Opposed to Inflation Indexed Bonds, which are linked to the WPI have served no real purpose at all, Rajan plans to introduce CPI Inflation Indexed Certificates instead.

If this is the same sort that is the WPI lndexed bonds, then it will be useless. Both principal and interest are linked to inflation and people will see the difference only after many years. Households won’t easily buy such certificates unless interest rates are stable, which they are not.

A better bet is to simply pay out interest as per CPI inflation, monthly.

He ended his speech well:

The Governorship of the Central Bank is not meant to win one votes or Facebook “likes”. But I hope to do the right thing, no matter what the criticism, even while looking to learn from the criticism.

Will Rajan deliver? Some of the above are ambitious. Some require government participation. Others require us to be honest. And then, we need the international situation to cooperate – Syria, the taper, the debt ceiling and what not.

Even if he does nothing and just frees the rupee, that will be good enough for me. I believe we don’t need heroes. We all need the freedom to become heroes. I wish him the very best.


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