Transit Path For Indian Economy: Six Steps For Transforming The Elephant Into A Tiger

Transit Path For Indian Economy: Six Steps For Transforming The Elephant Into A Tiger
(Address delivered by Dr. K. C. Chakrabarty, Deputy Governor, Reserve Bank of India at the interaction with members of Delhi Chapter of the Young Presidents Organization at New Delhi on December 7, 2012)

Shri Prabhat Jain and other members of the Delhi Chapter of the Young Presidents Organisation! It is my pleasure to be here amidst some of the young captains of the Indian industry, who, I believe, would continue to guide their respective enterprises for a foreseeable future and make immense contributions in shaping the Indian Economy going forward. I have been asked to speak to you today on “transforming the elephant into a tiger” and in this regard, I would suggest six steps that I think are essential for such a transformation. However, at the outset, I thank the Delhi Chapter of the Young Presidents Organisation (YPO) for inviting me to share my thoughts on this important topic. YPO has really established itself as an extra-ordinary network of young global business leaders and a think tank on issues that are critical to economy, businesses and society. I am told the network has hosted some illustrious speakers in the past and therefore, I have to live up to high expectations. I believe the decades of my experience in commercial banks and in the Central Bank have provided me with insights into enterprise, governance, growth and society and their impact on nation-building, which, I would share with you today and hope you find them interesting and worth emulating. Let us now focus on the topic for the evening. Transforming the elephant into a tiger can mean different things to different people. In reality, the state of the art in genetic engineering still cannot contemplate such a modification. An Ang Lee or a Steven Spielberg can, of course, use computer generated special effects to bring about such a transformation. But it is time to get real - given that the metaphor of elephant is used to denote the Indian economy and deals with our lives and the future of our children. In 2007, Dr. Shashi Tharoor wrote an enchanting book, ‘The Elephant, The Tiger and The Cellphone: Reflections on India: - The Emerging 21st Century Power’. The book, ingrained in history, culture and socio-economic change, criss-crosses the Indian life from Ajanta-Ellora and cricket to cellphones and call centres and makes a simple point of Indian growth effecting change in daily lives and imparting confidence to the Indian people. In December 2008, the Economist of London published a special report that India was elephant, not a tiger. It noted that for all its chaos, bureaucracy and occasional violence, India has had a remarkably successful past few years. But, it wondered how it will cope with an economic downturn and the general elections that were about to follow. It added that the democracy tax was rising and storm-clouds were gathering. The prognosis, however, were proven to be off beam by the events that followed. The elections removed uncertainty and the Indian economy staged a V-shaped recovery clocking 8.4 per cent growth during 2009-10 and 2010-11. Yet, we lost steam and the chinks in the tiger skin that we tried wearing, got exposed. In July 2011, Shri Swaminathan Anklesaria Aiyar, my journalist friend and a profound observer on the political economy of India, wrote a paper for the Cato Institute, “The Elephant that Became a Tiger”. In this paper he persuasively argued that 20 years of economic reforms in India had transformed the Indian economy into a tiger. Later the same year, the Reserve Bank Governor Dr. Subbarao, while delivering the Haksar Memorial Lecture, argued that India may be an elephant, but even elephant can dance. The elephant dance was disrupted by the zoo party in the form of global financial crisis. He then suggested ten steps to get back on course by re-jigging the elephant dance. Growth in India has clearly slowed down since then to 6.5 per cent in 2011-12 and a likely 5.8 per cent in 2012-13, with significant downside risks. The twin deficits – fiscal and balance of payments – have compounded our problems. This may set us thinking on whether we are an elephant or a tiger or a goat, about to be devoured by global forces and our domestic inaction? So should we at all pursue the tiger dream? If yes, what do we need to do to earn the tiger tag? The elephant and the tiger: Which one should we prefer? Before I touch upon what we need to do, the first step is to understand what these metaphors mean. So let me upfront visit the key attributes of elephants & tigers. There are four key attributes of an elephant – the size, the herbivores nature, its perceived moderate pace and its anatomy that includes large ears, the trunk and the tusks. Tiger, on the other hand, is not as large as the elephant, but is largest of the cat species. It is carnivore, and is known for its speed and agility. Its anatomy includes the stripes, the powerful jaws and razor sharp teeth, sharp claws and a flexible backbone. But, what conclusively differentiates the two is the tiger’s killer instinct. I think, in terms of size, the Indian economy is, of course, an elephant. It is also herbivores by habit given its democratic structure, unlike the carnivore habits of tigers and dragons. In terms of speed, many people have a misconception that elephants can’t run or walk fast. The fact is that elephants can walk as fast as 25 miles per hour (mph), while tigers can run only a shade faster. Bengal tigers can run at 35 mph, but for short spurts and they can’t keep this pace for long. So, in my view, it is not axiomatic that one should try transforming the elephant into a tiger. Yes, we could do with an added bit of speed but what we should really aim at is developing a tiger’s killer instinct. These, together with a better use of our anatomy or resources, both human and capital, would help us achieve what the dragons and the tigers have achieved, perhaps, with a smaller downside. For this to happen, in my view, we need to take the following six steps: 1. Preserve Demographic Dividends by investing in human capital India’s demographic dividend presents the country with a great opportunity to enhance its growth and seek convergence of per capita incomes with that in the developed world. India’s birth rate has fallen from 45.6 per 1000 in 1951 to an estimated 21 currently, but still remains highly driven by a slowly falling infant mortality rate that remains high at about 46 per 1000. The death rate has fallen dramatically from 37.2 per 1000 birth in 1951 to an estimated 7 currently, but has still not caused population ageing. Median age for India’s population is about 27 years compared with over 40 for most OECD economies. It will add significantly to its labor pool and, even as the median age bucket rises, it will still be at a relatively young 30-34 age bracket by 2026. India’s age-dependency ratio (ratio of dependents-people younger than 15 or older than 64-to the working-age population) is currently about 54. This is already lower than Japan and France. Most developed countries would see a rapid ageing of their population over the next 2-3 decades putting severe pressure on their social security systems with the rise in dependency ratio. The overall median age of these countries rose from 29.0 in 1950 to 37.3 in 2000, and is forecast to rise to 45.5 by 2050. Many developing countries like China, Brazil and Thailand too face issues of ageing population having passed through the demographic transition. Over the last 60 years, China has experienced demographic change at a historic pace that had a profound impact on its population structure. Baby boom began in the mid-1960s after the period of ‘Great Leap Forward’ saw famines and a sharp rise in death rate and a fall in birth rate. China is now a 'post-transitional' society, where life expectancy has reached new heights, fertility has declined to below-replacement level, and rapid population ageing is expected over the next few decades. China’s population will start to shrink after reaching a peak of about 1.4 billion by 2025 A.D. The median age of its population could touch 50 years by then. India’s population would overtake that of China at that point. Its population is expected to peak only at 1.7 billion by 2060 A.D. Clearly, India has a potential advantage of demographic dividend over its emerging market peers. But, this demographic dividend could be a boon or a curse depending upon how we exploit it, for, the time to reap these gains is finite. By the turn of this century, India would be facing a demographic discount rather than dividend because India’s population would have aged and the developed countries’ population would be much younger. So what do we need to do to reap the demographic dividend while they exist? The very first thing is to invest in the resources that are expected to give us advantage. India invests much less than it should in its human capital. The combined spend of central and state governments in education, is just about 3.3 per cent of GDP, while that on health is another 1.3 per cent of GDP. In contrast, the European Union (EU) countries spend from their general government account, 5.5 per cent of their GDP on education and 7.5 per cent of their GDP on health – i.e. nearly three times more of their GDP. Canada’s public spending on health alone is over 11 per cent of their GDP and that on education is nearly 5 per cent. India needs to step up its public spending on education and health considerably over the next five years. However, spending alone does not guarantee high quality human capital. We also need to focus on the quality of this spending and think whether we can achieve better outcomes with less spending. The second step we need to take is for right skilling of our work force. There is shortage of trained manpower for the industry, both at the bottom of the pyramid and higher up the ladder. India is often considered to be a source for skilled labour supply to the rest of the world, given its sheer size of manpower. It is often not recognized that over four-fifths of our rural population and over half of our urban population remains unskilled. Women participation rate in the labour market remains poor. The biggest problem is the lack of focus on technical education that could absorb a large chunk of unskilled labour, if backed by greater push to primary education. Less than 11 per cent of the job-seeking population in the age group of 15-29 receives any form of vocational training in India and only one of every three who do get vocational training receive it from specialized training institutes. Furthermore, even in the value added segment, where we have the largest pool of skilled manpower i.e. in the area of information technology, real wages are rising at a pace that may impact our competitiveness. The biggest challenge is to ensure jobs for additional supply of labour that comes in to join the workforce. On a rough basis, about 10 million people would need a job every year for the next 15 years. Though disguised unemployment in agriculture sector has reduced over the years, it may not be possible for the sector to provide additional jobs given the rising rural wages and the need to shift to a corporate, more mechanized and capital intensive model of farming. While the services sector has led India’s growth and employment story for some time now, India’s growth pace may not be sustained unless the manufacturing sector also becomes more competitive and creates lot more jobs. This poses a significant challenge in employment generation and skilling our work force. 2. Improve productivity and efficiency Productivity is an important driver of growth. Productivity depends on the efficiency with which scarce resources are allocated – be it your time, work effort, natural resources, capital or any other inputs. A great deal of the growth for most countries can be explained by productivity growth, especially total factor productivity growth (TFPG). Factor accumulation (such as increase in labour or capital) explains a smaller part of the growth. Given this experience, if India were to become a tiger, it would need to focus on technological developments to improve its rate of TFPG. Capital deepening may also help, but the key lies in overall productivity enhancements. In India, output per worker has increased at an impressive rate in the services sector after the reforms initiated in early 90s. In this period, TFPG growth has also been impressive for this sector, though I will eschew quoting precise numbers as the growth accounting research generally gives varied quantitative estimates. TFPG growth has also improved for the manufacturing sector since the 1980s. So, progress is being made. However, the rate of this technical change, still, has been lower than that for the East Asian economies during the period in which they earned the tag of being East Asian tigers. I would rather focus on the issue of larger policy initiative that would be necessary in the quest to transform India into a tiger. In this context, I would make four suggestions. First, improving agriculture productivity is necessary as, clearly, increase in area under cultivation is just not practical and, therefore, increasing demand for cereals, pulses, fruits and vegetables would need to be met by improving yields. Substantial productivity enhancements are possible on the farm through adoption of precision farming techniques, better cultivars and optimal water management. Better adoption of modern technologies in the area of biotechnology, genomic tools, cost-effective and eco-friendly integrated pest management technologies, seed-supply chains and systems, regionally adapted varieties and hybrids, would help. Second, we need to focus on issues confronting our Small and Medium Enterprise (SME). SME sector accounts for over a third of our industrial output and contributes an equal share of our total merchandise exports. In the current downturn, SMEs are facing adverse business climate with rising receivables, inadequate credit and high cost of credit. SME sector does not enjoy the economies of scale and scope that a large corporation enjoys. It also cannot fully reap the benefit of information technology as it has high sunk cost and a high rate of obsolescence.  Though having strong links with large firms, institutional mechanisms for transfer of technology to SMEs are lacking. If SMEs are to effectively integrate with supply chains, we need to ensure that links of finance and technology with large firms work at all times. Third, as I mentioned a little earlier, India’s next growth push has to come from manufacturing sector. We had a missed century of opportunities. India cannot boast of one big ‘home grown’ global brand while much smaller nations like South Korea, Taiwan, etc. have plenty of them. Our abundant human capital has not been effectively channelized for supporting the manufacturing growth. But what I would really blame for this is a lack of ‘R & D’ culture that we suffer from. Globally, India figures at near the bottom in terms of R&D intensity. It spends less than one percentage of its GDP on R&D expenditure, Countries like Israel, Finland, Sweden, Korea, Japan, US and Germany have R&D intensities that are higher by three times or more. Fourth, a key issue related to productivity is our attitude to work. It is strange that India, that epitomised the dignity of labour in the Early Vedic period, has imbibed a culture that does not respect workers. We have forgotten Swami Vivekananda’s contribution in equating work to worship. No form of work, whether manual or intellectual is less inferior to the other. As a nation, we have been steadily neglecting our respect for dignity of labour. Since the manual labour does not receive the same respect as an intellectual work in India, work efforts are lost. This results in lower GDP and lower Welfare. Individuals idle away than take up a manual job. What else would explain the fact that labourers from poor states like Bihar, Orissa, UP, etc. migrate and work hard in the agricultural farms in Punjab and Haryana, while refusing to do the same in their own locality where the land is more fertile and same amount of labour would be much more productive. We must emulate the western society in this regard where no form of labour is discriminated against. If President Cleveland could accept dignity of labour in 1894, more than a century down the line it is time that we give respect to casual labour that operates around us – be it our maids, our drivers or the workmen in our factories – a due recognition and respect. If we do so, more women and men would join the workforce. Unemployment would be reduced and Indian industry would become more competitive globally. 3. Revive infrastructure investments and harness natural resources better Much has been said about India’s infrastructure deficit and rightly so. India does not have sufficient roads, nor sufficient power. When I was growing up, I was taught that India is a land of poor, but is rich in resources. Today we have made a giant leap in lowering poverty and still remain abundant in natural resources. Yet, we have not learnt to optimally utilise them. Take for example coal, which accounts for India’s 55 per cent of energy needs. We have hard coal reserves of around 246 billion tonnes, of which 92 billion tonnes are proven. Yet, we are able to produce only 530 million tonnes of coal, leaving supply shortages of over 150 million tonnes. Coal shortages are constraining our power generation and though about 55 GW of new capacity was created during the 11th Five Year Plan (FYP), a large part of it remains unutilised due to coal shortages. Private sector has failed to develop most of the new coal blocks that were allotted to them. We ended up with inadequate planning and poor execution in this area. We are now planning to create even more thermal power capacity during the 12th FYP, but remain unsure of coal supplies. At the same time, banks have heavily extended themselves into lending to power sector both on generation and distribution side. On the distribution side, the State distribution companies (discoms) are sitting on huge losses and bank debt that is threatening to go bad.  The end result is a loss of business confidence that has brought the investment boom to a premature halt. What is most important in this context is to revive the confidence for investing and lending to the infrastructure sector. The government, in recent period, has taken several steps to facilitate this. The broad contours of the New Fuel Supply Agreements (FSAs) have been worked out, though some thorny issues such as price pooling of imported and domestic coal are still to be resolved. These pending issues must be solved quickly. Similarly, a debt restructuring package for the discoms has been worked out. The private sector must seize the initiative and rekindle the Schumpeterian spirit at this juncture. Banks also need to perform their core banking business while balancing risk assessment with the functional need to support growth. We also need to harness our natural resources much better. Take the simple example of water. We are a country blessed with water resources with a network of perennial rivers and abundant rainfall. The rainfall provides four times the water that we use annually. Yet, water is a scarce resource in India. We haven’t harnessed our resources enough and haven’t planned the storage and distribution of water efficiently. India’s per capita storage capacity is significantly lower than that of other countries. For example, the quantum of water that can be stored as a proportion of average river runoff for India is just 50 days of average runoff  with wide variations—from 220 days in the Krishna to just two days in the Brahmaputra/Barak Basin. The comparable figures for the Colorado River Basin and Australia’s Murray-Darling Basin are 900 days while for South Africa’s Orange River Basin it is 350 days. Better water management could radically alter the agriculture situation in India. India also needs to utilize its mining, spectrum and air resources better. The importance of clean air is often not recognized. We need to strike a right balance between our development needs and environmental commitments to ensure long-run growth sustainability. We are not among the world’s top polluters. It needs to be recognized that average per square kilometre carbon dioxide (CO2) pollution in Japan is 7.5 times more than in India.  Similarly, per capita CO2 emission by India is amongst the least globally. Nevertheless, we also need to note that air pollution has serious health costs and India ranks fourth in the list of the largest CO2 pollutants after China, US and Russia. As such, if we want to ensure not just fast growth but also good quality growth sustainable for a fairly long period of time, we must continue to make efforts to exploit natural resources in an environmentally friendly way. 4. Improve governance at every level The World Bank’s worldwide governance indicators 2006-11 place India below average on key parameters of governance. It scores about 15 per cent on political stability and absence of violence, 40 per cent on control on corruption as well as regulatory quality, 55 per cent on rule of law as well as government effectiveness, while 60 per cent on vice and accountability. Clearly, there is lot of scope for improvement on these parameters. Both, our overall governance and corporate governance needs improvement. In fact, we need better governance at every level – from hospital and schools to polity, firms, non-profit institutions, sports, banking and finance, regulation, land records and even in our daily lives. Our governance deficit, in some form, is reflected in our ranking on ease of doing business. According to the IFC-World Bank Report 2013 released this year, India ranks 132nd on the index measuring ‘ease of doing business’ amongst 185 economies. Singapore and Hong Kong got the top and second spots overall. In its sub-components, India stands at an impressive 23rd on the criteria of ease of getting credit and 49th in terms of protecting investors. However, it figures at 173rd in terms of starting a business, 182nd in terms of dealing with construction permits and 184th in contract enforcement. According to the same report, on an average, in India it requires 173 days to start a business, 196 days for obtaining a construction permit and 67 days to get electricity. In Singapore one needs just 3 days to start a business, 26 days for construction permit and 36 days for getting electricity. All other East Asian tigers also have a far superior record than India on these parameters. If we aspire to become a tiger we must become more business friendly, both for domestic and foreign firms, traders and tourists. We, of course, have an enviable record of a democratic system, a responsive government, an active media and an independent judiciary. However, the risk of dealing with India must come down further. We have to reach where the East Asian tigers reached. It is for this reason that we advocated the adoption of Singapore model in the last RBI Annual Report. In a limited way, this is being attempted in the form of National Investment Board (NIB). A well-functioning NIB can go a long way in cutting project delays. However, in our federal structure, NIB would still have some limitations. It will not have jurisdiction over project clearances that are required at sub-national levels. The Singapore model is a step further. It requires all concerned agencies to sit together in a time bound manner to clear or reject projects, failing which the clearance is deemed to be automatic. We must make doing business easy, to unleash entrepreneurship and venture capitalism in India. We also need to improve our record of corporate governance in both financial and non-financial firms. Barriers to entry must collapse and a more competitive environment needs to be generated. However, we must develop a framework and inculcate practices of arms length relationships that do not permit connected lending and business relationships that may promote “looting” behaviour as described by Akerlof (awarded the Nobel Prize in 2001) and Romer. They argued that an economic underground can come to life if firms have an incentive to go broke for profit at society’s expense (to loot) instead of to go for broke (to gamble on success). Bankruptcy for profit will occur if poor accounting, lax regulation, or low penalties for abuse give owners an incentive to pay themselves more than their firms are worth and then default on their debt obligations. There is still a large gap arising from our nominal compliance of good corporate governance in accordance with regulatory provisions and real compliance of practicing it in law and spirit. We need to bridge this gap.  5. Enforce Accountability in all walks of life All the other five steps that I talk of in this address, including real compliance of good governance cannot be achieved unless we enforce accountability. Just as we need better governance at every level, we also need to enforce accountability in all walks of life. Our accountability structures, especially in public sector, are weak. In administration, the civil servants are insufficiently incentivized for the risks they take, are seldom rewarded for successful completion of their goals and are, at best, merely transferred for poor implementation. Mangers in public sector enterprises face similar problems in addition to bureaucratic interventions that delay decisions or require them to move away from policies which may be in the best interests of a public sector unit. It is difficult to enforce accountability in this climate. On corporate accountability, the principal-agent relationship between the management or those who wrest ownership and control and the shareholders as actual owners is rather weak. We have seen asset stripping and bankruptcies in this weak environment. This has been especially true where a complex web of companies within business groups prevail. There is a strong case for simplifying these structures that are often developed to evade taxes, indulge in regulatory arbitrage and to strip assets of the firm for personal use. In recent period, we have come across instances where corporate debt restructuring is sought but ownership commitment of those who have control is rather left weak. We must enforce accountability in such cases by forcing such business entities to bring in more of their capital. There are, sometimes, grave cases of businessmen launching new firms, renaming firms or indulging in M&As to garner fresh public money after they misused funds in the first instance. The concept of the modern firm based on limited liability principle requires care to prevent such practices. Our political process ensures a fair deal of accountability through our democratic institutions. Yet, there is debate on whether a right to recall should exist. A more fragmented polity and existence of coalitions and minority governments, sometimes, make matters worse. Accountability at the municipal levels is also lacking. This, in turn, impacts the upkeep of our infrastructure that gets built. Roads seldom last more than a year. Drainage systems choke. What is, therefore, necessary in this climate is to do four things. First, stakeholder engagement must be intensified in all institutions – public or private. Furthermore, there should be a principle of inclusivity in stakeholder engagement so that any sort of regulatory capture by interest groups is avoided. Second, individuals, rather than committees or groups, should be made accountable even where a collegiate approach is adopted. Such accountability should not be time barred by transfers of jobs or retirements. Third, financial accountability must be enforced for all. For enhancing fiscal transparency, the budgetary processes should be made tighter so that slippages are eliminated. Similarly, financial accountability needs to be promoted for firms and non-profit institutions. Fourth, accountability should be codified to the degree it can be done and a periodic evaluation must be done to assess achievement, failures and correctives. 6. Make finance more responsive to real sector and promote inclusive growth Let me, at last, cover the role of finance in India’s transformation from elephant to tiger. I have kept this for the end because this is where finance should belong to. In recent period, finance has become big and rather than responding to the real sector needs, it is leading the real sector. Too-big to fail syndrome, firms depending on other incomes to shore up their accounts, market herd behaviour driven by noise rather than fundamentals, are all examples of finance sector becoming too big for its boots. Yet, the finance to support real activity is still inadequate. Firms and businesses still get crowded out by information asymmetry. Financial frictions and financial constraints come in the way of investment and growth in the economy. For want of collaterals, the poor cannot access even elementary banking services, resulting not only in some potential saving getting lost but leaving the society more unequal and polarized with insufficient support for Pareto superior outcomes just because gainers can’t compensate the losers. Finance must be regulated more tightly. This does not require more regulations but perhaps less and newer regulations with greater effectiveness. At the same time, those who engage in finance must have an obligation towards promoting financial inclusion, without which inclusive growth cannot be achieved. Banking should have a human face for it is the households who provide the base for all banking activities. They are the only ones with financial surpluses which can be intermediated to corporate and public sectors that run financial deficits. It has been my endeavour to push policies on bank lending with a view to encourage credit flows to the vulnerable section of the population that would otherwise get financially excluded. Over the years, this has been the ethos of the Reserve Bank. The branch licensing policy and the directed lending route have been the two pillars on which the efforts for financial inclusion have rested for a long time. The bank licensing policy, mandating a certain ratio of rural bank branches for each license for urban branch, has often been criticised by banks as coming in the way of their business interests. However, there is strong research evidence to suggest that this social banking experiment in India has been successful in improving the credit flows to the rural population and even in lowering poverty as a result. The priority sector lending (PSL) stipulation has also improved the flow of credit to certain productive sectors of the economy that would otherwise have been crowded out of the bank credit market due to information asymmetries. There are reasons to believe that with proper planning and use of technology-enabled efficient delivery channels, banks can pursue financial inclusion in a profitable way. Our approach should not be seen as being interventionist. In practice, Reserve Bank has deftly balanced objectives of equity and efficiency so that financial inclusion is furthered, but banks’ financial health is not impaired. In more recent period with which I have been associated, we have redoubled our efforts at financial inclusion. For instance, the prescription for PSL in respect of foreign banks has been raised from 32 per cent to 40 per cent in case of those banks which have 20 or more branches. We have also imparted a more human touch to basic banking for those who did not have bank accounts. Conclusion Let me end by talking about something we need to learn from the East Asian tigers in our quest to become one. Growth acceleration in these tigers were supported by liberalization, export-led growth, high investment in education, large share of educated workforce, high public and private savings rate and macroeconomic discipline and governance.  We are pursuing some of these policies and can pursue some more of them. However, these tigers also failed to maintain their spurt because of some mistakes they committed. Some of them maintained high interest rate to attract foreign investments, others pegged currency arrangements and many of them developed a vulnerable financial system. An unanticipated shock from banking and currency side, therefore, resulted in growth collapse for them during the East Asian crisis. Corporate failures added to the financial sector woes in some countries (especially Chaebols in Korea). While transforming the Indian economy into a tiger, we need to calibrate policies taking into account the lessons learnt during the East Asian crisis. Thank you for your patient hearing. Downturns come and go away as business cycles run their course. In our present predicaments with macro-economic stabilization, we must not lose sight of our larger goals, whether we walk at an elephant’s pace or run like a tiger. Let me assure you that as a society, if we can inculcate an aggressive and tenacious urge to attain a set goal- the killer instinct of the tiger- we would definitely earn our rightful place under the sun. Bibliography Aiyar, Swaminathan Anklesaria (2011), “The Elephant That Became a Tiger: 20 Years of Economic Reform in India"  Cato Institute, Development Policy Analysis, no. 13, July 20, 2011. Akerlof, George A. and Paul M. Romer (1993), “Looting: The Economic Underworld of Bankruptcy for Profit”, Brookings Papers on Economic Activity, Vol. 1993, No. 2 (1993), pp. 1-73 Bosworth, Barry and Susan M. Collins (2007), “”Accounting for Growth: Comparing China and India”, NBER Working Paper No.12943, February. Tharoor, Shashi (2007), The Elephant, The Tiger and the Cellphone: Reflections on India: - The Emerging 21st Century Power, New York: Arcade Publishers Subbarao, Duvvuri (2011), “Rejigging the Elephant Dance”, Haksar Memorial Lecture delivered by Dr. Duvvuri Subbarao, Governor, Reserve Bank of India at the Centre for Research in Rural & Industrial Development, Chandigarh on November 25, 2011, reprinted in RBI Bulletin, December 2011, p.2041-48.  World Bank and IFC (2012), Doing Business 2013: Smarter Regulations for Small and Medium Enterprises, Washington, The World Bank 1 Address delivered by Dr. K. C. Chakrabarty, Deputy Governor, Reserve Bank of India at the interaction with members of Delhi Chapter of the Young Presidents Organization at New Delhi on December 7, 2012. Assistance provided by Dr. Mridul Saggar in preparation of this address is gratefully acknowledged.

Money Market and Monetary Operations in India

Money Market and Monetary Operations in India
(Speech by Shri Deepak Mohanty, Executive Director, Reserve Bank of India, at the Seminar on Issues in Financial Markets, Mumbai, 15th December 2012)

I thank Mr. G. Mahalingam for the opportunity to share my thoughts in this distinguished panel on money market. This forum which brings together the Reserve Bank and practitioners in the financial market, is important not only from the perspective of market development but also for fostering a better understanding of monetary operations. Money market is at the heart of monetary operations. Over the last decade, there has been substantial development in the Indian money market in terms of depth, variety of instruments and efficiency. This has enabled the Reserve Bank to change its monetary operations from direct quantity based instruments to indirect interest rate based instruments to enhance the efficiency of monetary transmission consistent with international best practice. Against this background, I will briefly capture the developments in the money market and discuss the experience with the recently modified operating procedure of monetary policy before concluding with some thoughts on the way forward. Role of money market Money market can be defined as a market for short-term funds with maturities ranging from overnight to one year and includes financial instruments that are considered to be close substitutes of money. It provides an equilibrating mechanism for demand and supply of short-term funds and in the process provides an avenue for central bank intervention in influencing both the quantum and cost of liquidity in the financial system, consistent with the overall stance of monetary policy. In the process, money market plays a central role in the monetary policy transmission mechanism by providing a key link in the operations of monetary policy to financial markets and ultimately, to the real economy. In fact, money market is the first and the most important stage in the chain of monetary policy transmission. Typically, the monetary policy instrument, effectively the price of central bank liquidity, is directly set by the central bank. In view of limited control over long-term interest rates, central banks adopt a strategy to exert direct influence on short-term interest rates. Changes in the short-term policy rate provide signals to financial markets, whereby different segments of the financial system respond by adjusting their rates of return on various instruments, depending on their sensitivity and the efficacy of the transmission mechanism. How quickly and effectively the monetary policy actions influence the spectrum of market interest rates depends upon the level of development of various segments of financial markets, particularly the money market. Cross-country studies suggest that as domestic financial markets grow, transmission of monetary policy through various channels becomes better. As a crucial initial link in the chain through which monetary policy aims at achieving ultimate goals relating to inflation and growth, money market developments are closely monitored and influenced by central banks. Besides expecting money market rates to respond to policy rate changes in a well anchored manner, central banks aim at ensuring appropriate liquidity conditions through discretionary liquidity management operations so that money market functions normally. Money market is also an important funding market for banks and financial institutions, and at times, even for corporates. Stressed conditions in the money markets could increase moral hazard with banks expecting a central bank to function as the lender of first resort. Following the recent global financial crisis, money market funding for the financial system effectively got replaced with central bank funding in advanced countries. Money market rates (like LIBOR and EURIBOR) are standard benchmarks for pricing of bonds, loans and other financial products. Market manipulation of this key benchmark – as reportedly happened to LIBOR recently - though undermined the faith in money market. A sound money market would have to ensure conditions where banks can conduct business safely. Money market transactions could be both secured and unsecured, i.e., without collaterals. What does one expect from the secured and unsecured markets? The unsecured market should primarily promote market discipline. Loans being uncollateralised in this market, lenders are directly exposed to the risk of non-repayment. This works as an incentive for them to address information asymmetry by collecting information about borrowers. It is the constant peer monitoring that promotes market discipline. In the secured segment of the money market, the lender may address credit risk concerns by asking for sound collaterals and also applying some haircuts, but the peer monitoring could potentially then be less emphasised. Conditions of market stress can lead to collateral scarcity and falling value of collaterals could stifle even the secured money market. Illiquidity spiral from the financial markets, i.e., when financial instruments held as assets turn illiquid, may lead to a situation where central banks would be required to dilute the collateral standards for liquidity injection, and even exchange good quality securities against securities facing illiquidity risks. This becomes necessary to unfreeze the markets in general. After the global crisis, asset quality, particularly liquidity, has received greater policy focus. Money market rates also reflect market expectations of how the policy rate could evolve in the near term. As per standard expectations hypothesis, money market rates for different time duration should equal expected future short-term rates, plus term premium and risk premium. Bernanke (2004)1 had examined how expectations of the likely future course of the federal funds rate respond to the Fed’s policy actions and statements and noted that “...Our findings support the view that FOMC statements have proven a powerful tool for affecting market expectations about the future course of the federal funds rate”. Empirical research suggests that if the shortest end of the money market, which is influenced the most by policy rate, is stable, or less volatile, then it may help in keeping term premium lower, compared to a period when volatile short rates get transmitted to the entire money market and simultaneously the term premium rises. With the sophistication of financial markets rendering the money, output and price relationship unstable, by the early 1980s, major central banks began to emphasise on the price channel, i.e., policy interest rate for monetary policy transmission. As a result, the role of money market became all the more important for signaling and transmission of monetary policy. Thus, the development of money markets across countries in terms of instruments and participants with varying risk profiles has necessitated changes in the operating procedures of monetary policy. In the case of India, the ultimate goals of monetary policy, i.e., price stability and growth, have remained unchanged over the years. In the recent years, financial stability has been considered as an additional objective of monetary policy. However, operational and intermediate objectives of monetary policy have undergone periodic changes in response to changes in the economic and financial environment. The development of the money market over the years and relative stability in the call money market enabled the Reserve Bank to move away from quantity-based instruments to price-based instruments under its multiple indicators approach adopted since 1998. Accordingly, the overnight call rate, which was used implicitly as operating target since the institution of liquidity adjustment facility (LAF) in 2000, became explicit after the adoption of a new operating procedure in May 2011. Money market in India Financial reforms in India began in the early 1990s. However, various segments of domestic financial markets, viz., money market, debt market and forex market underwent significant shifts mainly from the 1990s. Earlier, the Indian money market was characterised by paucity of instruments, lack of depth and distortions in the market micro-structure. It mainly consisted of uncollateralised call market, treasury bills, commercial bills and participation certificates. Following the recommendations of the Chakravarty Committee (1985), the Reserve Bank adopted a monetary targeting framework. At the same time, efforts were made to develop the money market following the recommendations of Vaghul Committee (1987). In this regard, important developments were: (i) setting up of the Discount and Finance House of India (DFHI) in 1988 to impart liquidity to money market instruments and help the development of secondary markets in such instruments; (ii) introduction of instruments such as certificate of deposits (CDs) in 1989 and commercial papers in 1990 and inter-bank participation certificates with and without risk in 1988 to increase the range of instruments; and (iii) freeing of call money rates by May 1989 to enable price discovery. However, the functioning of the market continued to be hindered by a number of structural rigidities such as skewed distribution of liquidity and the prevalence of administered deposit and lending rates of banks. Recognising these rigidities, the pace of reforms in money market was accelerated. Following the recommendations of an Internal Working Group (1997) and the Narasimham Committee (1998), a comprehensive set of measures was undertaken by the Reserve Bank to develop the money market. These included: (i) withdrawal of interest rate ceilings in the money market; (ii) introduction of auctions in treasury bills; (iii) gradual move away from the cash credit system to a loan-based system. Maturities of other existing instruments such as CP and CDs were also gradually shortened to encourage wider participation. Most importantly, the ad hoc treasury bills were abolished in 1997 thereby putting a stop to automatic monetisation of fiscal deficit. This enhanced the instrument independence of the Reserve Bank (Table 1). Table 1 : Major Developments in Money Market since the 1990s 1. Abolition of ad hoc treasury bills in April 1997 2. Full fledged LAF in June 2000. 3. CBLO for corporate and non-bank participants introduced in 2003 4. Minimum maturity of CPs shortened by October 2004 5. Prudential limits on exposure of banks and PDs to call/notice market in April 2005 6. Maturity of CDs gradually shortened by April 2005 7. Transformation of call money market into a pure inter-bank market by August 2005 8. Widening of collateral base by making state government securities (SDLs) eligible for LAF operations since April 2007 9. Operationalisation of a screen-based negotiated system (NDS-CALL) for all dealings in the call/notice and the term money markets in September 2006. The reporting of all such transactions made compulsory through NDS-CALL in November 2012. 10. Repo in corporate bonds allowed in March 2010. 11. Operationalisation of a reporting platform for secondary market transactions in CPs and CDs in July 2010. More importantly, efforts were made to transform the call money market into primarily an inter-bank market, while encouraging other market participants to migrate towards collateralised segments of the market, thereby increasing overall market stability and diversification. In order to facilitate the phasing out of corporate and the non-banks from the call money market, new instruments such as market repos and collateralised borrowing and lending obligations (CBLO) were introduced to provide them avenues for managing their short-term liquidity. Non-bank entities completely exited the call money market by August 2005. In order to minimise the default risk and ensure balanced development of various market segments, the Reserve Bank instituted prudential limits on exposure of banks and primary dealers (PDs) to the call/notice money market. In April 2005, these limits were linked to capital funds (sum of Tier I and Tier II capital) for scheduled commercial banks. In order to improve transparency and efficiency in the money market, reporting of all call/notice money market transactions through negotiated dealing system (NDS) within 15 minutes of conclusion of the transaction was made mandatory. Furthermore, a screen-based negotiated quote-driven system for all dealings in the call/notice and the term money markets (NDS-CALL), developed by the Clearing Corporation of India Limited (CCIL), was operationalised in September 2006 to ensure better price discovery. Beginning in June 2000, the Reserve Bank introduced a full-fledged liquidity adjustment facility (LAF) and it was operated through overnight fixed rate repo and reverse repo from November 2004. This helped to develop interest rate as an important instrument of monetary transmission. It also provided greater flexibility to the Reserve Bank in determining both the quantum of liquidity as well as the rates by responding to the needs of the system on a daily basis (Chart 1). In the development of various constituents of the money market, the most significant aspect was the growth of the collateralised market vis-à-vis the uncollateralised market. Over the last decade, while the daily turnover in the call money market either stagnated or declined, that of the collateralised segment, market repo plus CBLO, increased manifold (Chart 2). Since 2007-08, both the CP and CD volumes have also increased very significantly (Chart 3). Furthermore, issuance of 91-treasury bills has also increased sharply (Chart 4). The overall money market now is much larger relative to GDP than a decade ago. Alongside, the rates of return on various instruments in the money market have shown greater co-movement, especially since the introduction of LAF (Table 2 & Chart 5). Table 2: Interest Rates in the Money Market (Percent per annum: Annual Averages) Repo Rate Call Rate CBLO Rate Market Repo Rate 91 day T-Bills 364-day T Bills CP Rate CD Rate 1 2 3 4 5 8 9 6 7 2000-01 11.2 9.1 - - 9.0 9.8 10.8 9.6 2001-02 8.5 7.2 - - 7.0 7.3 9.2 8.0 2002-03 7.7 5.9 - - 5.8 5.9 7.7 6.6 2003-04 7.0 4.6 - - 4.6 4.7 6.1 5.3 2004-05 6.0 4.7 - - 4.9 5.2 5.8 5.0 2005-06 6.2 5.6 5.3 5.4 5.7 6.0 6.7 6.1 2006-07 7.0 7.2 6.2 6.3 6.6 7.0 8.5 7.9 2007-08 7.8 6.1 5.2 5.5 7.1 7.5 9.3 9.1 2008-09 7.4 7.1 6.1 6.5 7.1 7.2 10.7 9.2 2009-10 4.8 3.2 2.7 2.8 3.6 4.4 5.3 5.4 2010-11 5.9 5.7 5.4 5.5 6.2 6.6 8.7 7.7 2011-12 8.0 8.1 7.8 7.9 8.4 8.4 10.1 9.6 2013-14 (so far) 8.0 8.1 7.9 8.0 8.2 8.1 9.3 9.0 Monetary operating procedure The development of money market as well as its growing inter-linkages with other segments of financial markets enabled the Reserve Bank to alter the operating procedures of monetary policy consistent with the objectives of the monetary policy. Based on the recommendations of Chakravarty Committee (1985), a monetary targeting framework with feedback was introduced during the mid-1980s, under which reserve money was used as operating target and broad money (M3) as an intermediate target. By the mid-1990s, this framework was rendered increasingly inadequate due to several developments. Structural reforms and financial liberalisation led to a paradigm shift in the financing of government and commercial sectors with increasingly market-determined interest rates and exchange rate. Development in the various segments of the financial market led to deepening of the financial sector. This provided the Reserve Bank to effectively transmit policy signals through indirect instruments such as interest rates. On the other hand, increase in liquidity emanating from capital inflows raised the ratio of net foreign assets to reserve money and rendered the control of monetary aggregates more difficult. With financial innovations, the stability in the demand function for money also came under question. Recognising these challenges and the growing complexities of monetary management, the Reserve Bank switched to a multiple indicators approach in 1998-99. Under this approach, a host of macroeconomic indicators including interest rates in different segments of financial markets, along with other indicators on currency, lending by banks and financial institutions, fiscal position, trade, capital flows, inflation rate, exchange rate, refinancing and transactions in foreign exchange available on high frequency basis are juxtaposed with output data for drawing implications for monetary policy formulation. However, the approach itself continued to evolve and was further augmented by forward-looking indicators drawn from Reserve Bank’s various surveys and a panel of parsimonious time series models (Mohanty, 2011).2 Along with the multiple indicators approach, operating procedure also underwent a change following the recommendation of Narasimham Committee II (1998). The RBI introduced the Interim Liquidity Adjustment Facility (ILAF) in April 1999, under which liquidity injection was done at the Bank Rate and liquidity absorption was through fixed reverse repo rate. The ILAF gradually transited into a full-fledged liquidity adjustment facility (LAF) with periodic modifications based on experience and development of financial markets and the payment system. The LAF was operated through overnight fixed rate repo and reverse repo from November 2004, which provided an informal corridor for the call money rate. Though the LAF helped to develop interest rate as an instrument of monetary transmission, two major weaknesses came to the fore. First was the lack of a single policy rate, as the operating policy rate alternated between repo during deficit liquidity situation and reverse repo rate during surplus liquidity condition. Second was the lack of a firm corridor, as the effective overnight interest rates dipped (rose) below (above) the reverse repo (repo) rate in extreme surplus (deficit) conditions. Recognising these shortcomings, a new operating procedure was put in place in May 2011. Let me elaborate on the key features of the new operating procedure. First, the weighted average overnight call money rate was explicitly recognised as the operating target of monetary policy.3 Second, the repo rate was made the only one independently varying policy rate. Third, a new Marginal Standing Facility (MSF) was instituted under which scheduled commercial banks (SCBs) could borrow overnight at 100 basis points above the repo rate up to one per cent of their respective net demand and time liabilities (NDTL). This limit was subsequently raised to two per cent of NDTL and in addition, SCBs were allowed to borrow funds under MSF on overnight basis against their excess SLR holdings as well. Moreover, the Bank Rate being the discount rate was aligned to the MSF rate. Fourth, the revised corridor was defined with a fixed width of 200 basis points. The repo rate was placed in the middle of the corridor, with the reverse repo rate at 100 basis points below it and the MSF rate as well as the Bank Rate at 100 basis points above it (Chart 6). Thus, under the new operating procedure, all the three other rates announced by the Reserve Bank, i.e., reverse repo rate, MSF rate and the Bank Rate, are linked to the single policy repo rate. The new operating procedure was expected to improve the implementation and transmission of monetary policy for the following reasons. First, explicit announcement of an operating target makes market participants clear about the desired policy impact. Second, a single policy rate removes the confusion arising out of policy rate alternating between the repo and the reverse repo rates, and makes signalling of monetary policy stance more accurate. Third, MSF provides a safety valve against unanticipated liquidity shocks. Fourth, a fixed interest rate corridor set by MSF rate and reverse repo rate, reduces uncertainty and communication difficulties and helps keep the overnight average call money rate close to the repo rate. Let me now turn to a brief evaluation of the experience with the new operating procedure. In the implementation of the new procedure, the Reserve Bank prefers to keep the systemic liquidity in deficit mode as monetary transmission is found to be more effective in this situation (RBI, 2011).4 The Reserve Bank also announced an indicative liquidity comfort zone of (+)/(-) 1.0 per cent of net demand and time liabilities (NDTL) of banks. Since May 2011, the liquidity conditions can be broadly divided into three distinct phases. After generally remaining within the Reserve Bank’s comfort zone during the first phase during May-October 2011, the liquidity deficit crossed the one per cent of NDTL level during November 2011 to June 2012. This large liquidity deficit was mainly caused by forex intervention and increased divergence between credit and deposit growth. The deficit conditions were further aggravated by frictional factors like the build-up of government cash balances with the Reserve Bank that persisted longer than anticipated and the increase in currency in circulation. Accordingly, the Reserve Bank had to actively manage liquidity through injection of liquidity by way of open market operations (OMOs) and cut in cash reserve ratio (CRR) of banks. This was supported by decline in currency in circulation and a reduction in government cash balances with the Reserve Bank. As a result, there was a significant easing of liquidity conditions since July 2012 with the extent of the deficit broadly returning to the Reserve Bank’s comfort level of one per cent of NDTL (Chart 7). Since its implementation, the systemic liquidity has been in deficit mode, which has helped in better transmission of policy rate to various segments of money markets. First, the overnight interest rate has been more stable since its implementation (Chart 8). Second, the repo rate and weighted call rate are far more closely aligned under the new operating procedure than earlier; implying improved transmission of monetary policy in terms of movement in call money market interest rate (Chart 9). Third, the call money rate in turn is observed to be better aligned with other money market interest rates after the implementation of new operating procedure than before (Chart 10). Conclusion Let me conclude. Our experience shows that the development of money market and refinements in operating procedures of monetary policy have moved in tandem. Financial sector reforms along with Reserve Bank’s emphasis on development of various segments of financial market enabled shifts in operating procedures based on direct quantity-based instruments to indirect interest rate-based instruments. The Reserve Bank has been able to better transmit monetary policy signals in the money market through a single policy repo rate. Evidence so far suggests a significant improvement in monetary policy transmission under the new operating framework. In order to reinforce this process, I make three suggestions. First, there has been a swift transmission of policy rate at the short-end of money market, partly due to the prevalence of market liquidity in deficit mode. However, ensuring market liquidity in a deficit mode of desired level on a sustained basis is contingent on Reserve Bank’s ability to effectively conduct OMOs and the market appetite for such operations. Hence, there is a need to develop the market micro-structure and further enhance secondary market transactions in government securities to facilitate smooth conduct of OMOs. Second, the LAF is not the appropriate instrument for managing the liquidity of more enduring nature. As the system is expected to be in deficit, there is a need to develop term repo to minimise daily requirement of liquidity. Third, notwithstanding significant advances in developing the market, the term structure in the money market is incomplete. It is, therefore, desirable to extend the yield curve beyond the overnight rate by developing a term-money market. Thank you. *  Speech by Shri Deepak Mohanty, Executive Director, Reserve Bank of India, at the Seminar on Issues in Financial Markets, Mumbai, 15th December 2012.  The assistance provided by Sitikantha Pattanaik, Jeevan Khundrakpam, Binod Bhoi and Rajeev Jain is acknowledged. 1 Bernanke, Ben S. (2004), “Central Bank Talk and Monetary Policy”, At the Japan Society Corporate Luncheon, New York, October 7. 2 Mohanty, Deepak (2010), “Monetary Policy Framework in India: Experience with Multiple-Indicators Approach”, RBI Bulletin, March 2010. 3 Even though the share of call money market in the overnight money market is lower than that of collateralised segment, the weighted overnight call rate is used as operating target. This is partly on account of high correlation between the overnight call money rate and the collaterallised money market rate at 0.9. The issue was examined in detail by the Working Group on Operating Procedure of Monetary Policy which observed that the transmission of policy rate to the overnight call money rate is stronger than the overnight money market rate. In addition, the call money market is a pure inter-bank market and, hence, better reflects the net liquidity situation. 4 Reserve Bank of India (2011), Report of the Working Group on Operating Procedure of Monetary Policy (Chairman: Deepak Mohanty), March.

Supporting Explosive Growth: Effective Linkages between the Banking Sector and Real Sector

Supporting Explosive Growth: Effective Linkages between the Banking Sector and Real Sector (Keynote Address delivered by Dr. K. C. Chakrabarty, Deputy Governor, Reserve Bank of India at the Inaugural Session of the 8th Annual Banking Summit organised by the ASSOCHAM at New Delhi on November 21, 2012)

Introduction Shri Rajkumar Dhoot, Hon’ble Member of Parliament and President, ASSOCHAM, Shri M. Narendra, Chairperson, ASSOCHAM National Council for Banking & Finance and CMD, Indian Overseas Bank, Shri Sunil Kanoria, Vice President, ASSOCHAM and Vice Chairman, SREI Infrastructure Finance Ltd.; Mrs. Shubhada Rao, Senior President and Chief Economist, Yes Bank Ltd.; Mr. Subhash C Aggarwal, CMD, SMC Group; Ms. Sudha Ravi, Co-Chairperson, ASSOCHAM National Council for Banking & Finance and CEO, PHL Finance Ltd., Shri D. S. Rawat, Secretary General, ASSOCHAM, distinguished guests, ladies and gentlemen. It is a pleasure and privilege to be here at the 8th Annual Banking Summit organized by the ASSOCHAM on the theme “Poised for Explosive Growth”. Present Scenario 2. Post the wide ranging structural reforms of the 90s, the Indian economy has, until recently, been churning out impressive growth rates and is now firmly ensconced in the exclusive club of countries with GDP in excess of one trillion US dollars. However, as the dark clouds of economic gloom hover above the horizon with doomsayers painting a dismal picture for the future of the world economy, time is ripe for taking a hard look at the economic outlook for India at the present juncture and examine what we need to do in order to keep the Indian growth juggernaut rolling. 3. The pundits of doom are having a field day as the global scenario remains bleak with the Eurozone slipping into recession once again and the debt crisis continuing to batter southern Europe and gnawing at the economic performance of export driven Germany. An ebullient America had seen some green shoots of recovery, but the unemployment numbers, since, have not been encouraging and it is now facing a fiscal cliff. On the domestic front, though it is not all clear skies and sunshine with the growth engine slowing down, the growth is still way above that of the developed countries. India has been largely protected from the global economic crisis through a combination of strong regulation and supervision and policies which leaned against the wind and best suited our country, society and culture. Having said that, we cannot claim to have remained totally immune from global headwinds. The Indian economy, which had accelerated since the reforms, recording a growth of more than 9% before the crisis, has slumped to 5.5% in the first quarter of 2012 -13, with sequential downward revisions in estimated growth rate, which is now expected to clock around 5.8% in 2012-13. This, however, is a far cry from our actual potential. 4. With economic liberalization, we have moved away significantly from the ‘Hindu rate of growth’ which had stagnated around 3.5% during 1950-80. According to Dun & Bradstreet report titled ‘India 2020’, India is poised to become a $ 5.6 trillion economy by the year 2020. The report adds that Maharashtra, Gujarat and Andhra Pradesh will be amongst the most developed states in the country by 2020 and would, together, contribute 32 per cent of the overall GDP. The states which were, hitherto, lagging behind such as Madhya Pradesh, Bihar, Orissa, Rajasthan and Uttar Pradesh, are also expected to contribute significantly to India’s growth story during the current decade. 5. The 11th Five Year Plan carried the objective of faster and more inclusive growth. Rapid GDP growth, targeted at 9.0 per cent per annum, was regarded necessary to generate income and employment opportunities for improving living standards of the masses and to generate the requisite resources for financing social sector programmes aimed at reducing poverty and enabling inclusiveness. The economy performed well on the growth front, averaging 8.2 per cent in the first four years. Growth in 2011-12, the final year of the Eleventh Plan, which was originally projected at around 9.0 per cent, continuing the strong rebound from the crisis, was eventually recorded at 6.5 per cent. The slowdown of the economy in 2011-12 compared to the previous year was a phenomenon common to all major economies. 6. Undoubtedly, there has been a decline in growth, which cannot be solely attributed to the global slowdown. A part of it can be traced to domestic infrastructural and governance issues. The twin deficits, inflation and the supply side bottlenecks are some concerns that need to be quickly tackled to spur growth. The poser before India at this juncture is whether we can afford to relapse to the Hindu rate of growth and be content with being considered an emerging nation forever, or should we make efforts to take our due position among the leaders in the world arena? We cannot and must not revert to the Hindu rate of growth. 7. In order to overcome these challenges, we need to focus on the key areas of productivity, innovation and reforms, both at the level of the macro economy and at the individual firm/ enterprise level. These will help us overcome the various bottlenecks currently shackling our growth and put us firmly on the path of sustained high economic growth. It will ensure that we are able to leverage our strengths, some of which I would be alluding to subsequently, in order to create a conducive growth environment. These reforms need to involve all stakeholders and should, necessarily, leverage on technology, which has the potential to act as a force multiplier in our efforts towards productivity, innovation and reforms. I see that some of these topics would be the focus of the technical sessions slated for later in the day. I am sure these sessions will deliberate on how the various measures could be implemented in an effective and time bound manner. 8. The role of the financial sector in any economy is to subserve the needs of the real economy. Consequently, if the Indian economy has to fully realize its optimum potential, the financial sector would have to play a pivotal part. As we all know, our financial sector is predominantly bank-centric and therefore, the performance of the banking sector is crucial to the fate of the economy. The Indian banking system has come a long way since the Financial Sector Reforms, with the banks having served the economy remarkably well over the last two decades. Liberalization has resulted in greater autonomy for banks in business decisions, but with the concomitant responsibility of conducting business in line with the highest standards of corporate governance, customer service and a commitment to nation building, which encompasses financial inclusion. 9. There is no doubt in my mind that if the economic growth engine has to churn out a powerful performance, banks would, necessarily, have to be the prime mover. The domestic credit provided by the banking sector in India stands at an abysmally low level compared to many of our emerging Asian peers, let alone the advanced economies. There is enormous scope for the banks to expand their business to areas/sectors hitherto lacking formal credit. Domestic Credit of the Banking Sector to GDP (in %) 10. Banks have to develop the ability to maintain high growth levels over a sustained period of time. They also need to develop strong linkages with the real sector. These linkages should critically determine all aspects of banking operations including the kind of products and services offered, the pricing strategies, delivery channels adopted, sectors/ sub-sectors receiving focused attention, technology platforms adopted, etc. This linkage with the real sector will ensure relevance of banks as a key pillar in the economic system and enable them to fully meet their crucial role in nation building. Besides, by ensuring that the financial system grows in tandem with the real sector, build up of systemic risk through creation of asset price bubbles can be avoided. This lack of linkage between the financial system and the real sector was one of the critical factors contributing to the global financial crisis and hence, the importance of this linkage has been one of our important learnings from the crisis. What are our strengths? Demographic Dividend 11. Sometimes, like the mythological Hanuman, we need to be reminded of our strengths, first and foremost of which is the great demographic dividend that the country enjoys. India has a young population not only in comparison to advanced economies but also in relation to the large developing countries. According to the Approach Document to the Twelfth Five Year Plan, the labour force in India is expected to increase by 32 per cent over the next 20 years, while it will decline by 4 per cent in industrialized countries and by nearly 5 per cent in China. This ‘demographic dividend’ can lead to sustainable long term growth, provided two conditions are fulfilled. One, higher levels of health, education and skill development must be achieved. Two, an environment must be created in which the economy not just grows rapidly, but also promotes inclusion by generating good quality employment/ livelihood opportunities to meet the needs and aspirations of the youth. The demographic dividend has payoffs in creating a skilled, technology savvy work force, strong customer base and higher savings rates, thereby increasing the resources available for productive investments. The progress made in the field of education and literacy is leading our transformation from being the world’s back office to being a knowledge partner. Potential for Inclusive Growth 12. A recent internal study conducted by the Reserve Bank on the profile of customers of banks has heartening indicators. With increasing number of bank branches, the average population per bank branch has improved from 15,583 in 2001 to 12601 in 2012. As per latest census, 58.7 percent households were availing of banking services in 2011 as compared to 35.5 percent in 2001. With liberalization of the branch licensing policy and drive towards financial inclusion, the share of rural and semi urban branches in total new branches opened reached 69.8 percent during 2011-12 from a mere 23.2 percent in 2004-05.The share of hitherto unbanked centres in newly opened branches has been around 20 percent during 2011-12. Further efforts are required and are being made in view of the large number of unbanked centres in the country. The Reserve Bank has been encouraging banks to improve banking penetration through the Business Correspondent (BC) model, allowing ‘for-profit organizations’ to work as BCs, leveraging technology, including mobile technology, to deliver banking services as part of the drive to enhance financial inclusion. While there has been some progress, more ground needs to be covered before we achieve the goal of meaningful financial inclusion. The extent of financial exclusion is high when compared to some of the advanced as well as developing countries. In a cross country analysis of financial inclusion, we compare poorly at 10.64 branches and 8.90 ATMs per 0.1 million adults, say, as against Brazil, which has 46.15 branches and 119.63 ATMs per 0.1 million of the population. In this vast financially excluded populace lies our opportunity! 13. Growth, merely in terms of numbers, would not carry any meaning unless it reaches every section of society - the vulnerable, underprivileged and the marginalized. Public sector banks as well as RRBs have played a key role in expanding the branch network to rural India. However, since it has been observed that the benefits of Government schemes often do not reach the intended beneficiaries, Reserve Bank has been encouraging banks to implement Electronic Benefits Transfer (EBT). Since many such social security beneficiaries reside in villages with population of less than 2000, RBI has been giving thrust on expanding the benefits of EBT to all villages. SLBC convenor banks have, therefore, been advised to prepare a roadmap covering all unbanked villages with population of less than 2000 and allocate these villages to various banks for providing banking services in a time bound manner. Besides, banks also need to provide a BC touch point in each village, where brick and mortar branches are not available, for extending the provision of EBT services at the earliest. BCs could also provide door step services to EBT beneficiaries through regular visits to villages, thereby ensuring that all kinds of banking facilities are available in the long run through a mix of brick and mortar branches and BC networks. We have also recommended the one district-many banks-one leader bank model in our “Operational Guidelines for Implementation of EBT and its Convergence with Financial Inclusion Plan”, which would expedite implementation of EBT in a simple and scalable manner. Banks need to wholeheartedly work towards achieving these goals, not as a CSR activity, but rather by seeing this as a viable and profitable business opportunity. Likewise, banks should also pursue extending banking services like opening of Basic Savings Bank Deposit Accounts, etc. as a potential business proposition and not as a regulatory burden. It is in banks’ own interest to realize early that the population mass concentrated in financially excluded centers has the potential to drive their future growth and profitability and help place the economy in the fast track mode! Infrastructure Financing- Huge Potential 14. Stimulating growth puts the spotlight on developing infrastructure - an efficient public transport system, roads, public utility services, housing, educational institutions, locomotive plants, ports, container terminals, etc. - the entire gamut, which forms the backbone of any developing country. The increasing infrastructure requirements to support a growing economy call for enormous investment. A McKinsey estimate suggests that each year we may have to build about 700 - 900 million square meters of residential and commercial space, 350-400 km of metros and subways and 19000-25000 km of roads - a massive task and an equally massive opportunity for banks. The Approach Paper to the 12th Plan estimates that infrastructure investment will need to increase from about 8.0 per cent of GDP in the base year (2011-12) of the Plan to about 10.0 per cent of GDP in 2016-17. The total investment in infrastructure would have to be over Rs. 45 lakh crore or $ 1 trillion during the Twelfth Plan period. 15. Financing this level of investment will require larger outlays from the public sector, but this has to be coupled with a more than proportionate rise in private investment. Private and PPP investments are estimated to have accounted for a little over 30.0 per cent of total investment in infrastructure in the Eleventh Plan. Their share may have to rise to 50.0 per cent in the Twelfth Plan. Government’s proposal for modification in investment norms for pension and provident funds to channelize their large cash inflows into Infrastructure Debt Funds would also provide infrastructure projects with reliable sources of long term funding. The funding for infrastructure has not been a major constraint thus far and credit to infrastructure has continued to account for almost one third of bank credit to industry. There have, however, been other conspicuous stumbling blocks, viz. delay in policy promulgations, environmental clearances, land acquisitions, permissions, etc. which have contributed to delays and project over-runs. While Central and State Governments would have to deliver on easing these roadblocks and facilitating investments in the infrastructure sector, banks would also need to hone their credit appraisal, monitoring and risk management skills, keeping in view the long gestation period of infrastructure projects. This would ensure that the sector’s funding needs are met, while keeping the position of NPAs under stringent control. Challenges for Banks Need for Enhancing Productivity 16. The performance of banks in 2011 and 2012 have been somewhat muted due to the general slowdown in the economy and the higher interest rate environment. The balance sheet of Scheduled Commercial Banks (SCBs) reflected slower growth at 15.5 percent in 2011-12 as compared to 19.2 percent in 2010-11, with deceleration in credit growth. The increased cost of deposits impacted net profit of banks, which increased at a slower rate of 16.1 percent as compared to 23.2 percent during the previous year. Interest expended on deposits, along with increase in proportion of high cost term deposits, led to acceleration in the interest cost of banks. Net Interest Margins of banks dipped marginally compared to the previous year. An analysis of profitability of banks, however, reveals that profitability of foreign banks is higher than that of other bank groups. Though their share of total assets of the banking system stands around 7 percent, foreign banks account for close to 12 percent of profits of SCBs. A Du Pont analysis showed that foreign banks registered highest Return on Assets amongst bank groups due to better asset utilization, although their operating expenses to assets ratio was higher compared to other bank groups. Their higher profitability could be attributed to better fund management practices. This is an area where Indian banks would need to improve. 17. The profitability of SCBs would be under increased strain during 2012-13 due to higher level of NPAs. The gross NPAs of the banking system has increased from 2.36 percent in March 2011 to 3.25 percent in June 2012. Restructured standard accounts as a percent of gross advances have doubled from 2.7 percent in 2009 to 5.4 percent as at June 2012 with substantial increase in restructuring in certain sectors. Data indicates that restructuring is largely resorted to in case of industrial sector accounts, particularly, large industries, as against smaller borrowal accounts such as agriculture, micro and small enterprises. The persistently high level of NPAs and increase in restructured accounts continues to pose a significant constraint on banks’ abilities to reduce lending rates, thereby, in a sense, penalizing the honest borrowers. Corporates need to innovate and embrace technology to improve their productivity and efficiency so that their costs can come down, they remain competitive and continue to service their obligation as borrowers. Banks on their part must look to arrest the deterioration in asset quality by adopting better risk management practices like better credit appraisal, closer monitoring of borrowal accounts, greater information sharing among banks and by carrying out elaborate viability studies before restructuring. While NPAs/ restructuring of assets cannot be wished away, they need to be effectively curtailed so as to ensure that the lendable resources of banks are maximized. On its part, RBI has mandated banks to put in place an effective mechanism for information sharing by December 2012 and to sanction ad hoc loans/renewal of loans to new or existing borrowers only after obtaining/ sharing the information. Lack of Enabling Environment 18. According to the Doing Business Rankings 2013, India ranks way down at 132 out of 185 countries in the global index of countries in ‘Ease of doing business’; 41 places below China, 51 places below Sri Lanka and 116 places below Taiwan. Explosive growth can only be achieved if there is an enabling economic environment. This requires Governmental policies for quicker clearances, which encourage business and long term investment. Recently, some steps have also been announced to stabilize the Government finances and contain fiscal deficits within manageable levels. 19. Government has also taken steps to encourage public investment as well as public private partnerships in infrastructure and to tap into available technology and capital from around the world. I firmly believe that for achieving explosive growth, it is imperative that macroeconomic environment stabilizes, inflation and inflation expectations come down to comfortable levels and the twin deficits are contained. The steps initiated by the Government need to fructify into effective change. Opportunities Galore Customer Centricity 20. Every challenge is also an opportunity. A Boston Consulting Group study “Indian Banking 2020 - Making the Decade’s Promise Come True” estimates that the income group below the middle class with annual household income of Rs 90000 to Rs 2.00 lakh per annum will constitute the largest group of customers, increasing from an estimated 75 million households in 2010 to 120 million in 2020, constituting the ‘Next Billion’. This customer segment would increasingly demand affordable, low cost banking services. The challenge for banks is to extend the reach of banking services through bank branches/ATMs/BC model to tap the potential of this customer segment. Banks need to develop customer centric products and services. The pricing has to be right and affordable. Greater use of technology, including mobile services, could revolutionize banking. The potential of mobile banking is immense. The BCG study estimates that even if 25–30 percent of mobile users have GPRS / 3G activated, there would be 250 million to 300 million customers who would access banking services over the mobile. The Indian banking industry would have to innovate and build an efficient and low-cost framework for transaction banking. Going forward, customer satisfaction would be the buzzword for success and would set the winners apart from the laggards. Dream Big, Think Small 21. If we are to achieve explosive growth, banks would need to increasingly focus on the SME, agriculture and retail sectors. It is a fact of life that large corporates have easy access to huge loans across the banking sector, but they also account for a major segment of NPA/restructured accounts. On the contrary, the small borrowers/MSMEs continue to face difficulties in accessing bank finance due to perceived higher risk and lower ticket size. It needs to be appreciated in this context that the delinquencies in this segment are largely attributable to the inadequacy of finance and lack of support from the banks to the viable units at an appropriate stage. Banks must realize that through adequate appraisal, fair pricing and by extending proper handholding support to the MSMEs, the sector can be a potential game changer in terms of accretions to the banks’ bottom line. 22. Banks need to evolve business models and delivery channels which would bring down the cost of providing credit to the agriculture/ retail/ SME segments. We can achieve explosive growth if banks are able to customize and deliver cost effective products and services to this customer segment while simultaneously guiding and providing handholding support to these sectors. The fear of increase in NPAs cannot be a ground for depriving these sectors of timely and adequate credit. Besides translating into increased business opportunities for banks, these sectors can significantly contribute to employment generation and growth in savings, and would support GDP growth. 23. There is also a need to encourage incubation and development of new business ideas and providing funds to translate these into reality. Facebook would not have been a reality if angel investors Reid Garrett Hoffman and Peter Thiel had not funded Mark Zuckerberg. According to a BCG India study, India has 190,000 millionaires but only about 500 angel investors. The HNIs in India prefer to invest in real estate. While Venture capital funds, to some extent, do provide funding to start ups, much more needs to be done to develop a viable ecosystem where new ideas with potential for employment and wealth generation can flourish. Banks could consider providing funding to such innovations. Attitudinal Changes 24. Success demands change in the way banks do business, harness the power of innovation, recognize the huge potential at the bottom of the pyramid and reach out to them. Banks need to go the extra mile in financial literacy by educating the customers and understanding the ecosystem in which small businesses and agricultural operations grow and thrive. They need to learn to work in a partnership to finance sustainable business. 25. Success is not about financing seemingly safe large corporates by following the herd in a ‘me too’ manner. It is about changing mindsets, looking at untreaded paths, putting the customer above all and tapping the power of technology. This demands a committed workforce with the requisite technology, HR and risk management skills. It calls for re-skilling the existing workforce and hiring and retaining talent in the public sector, particularly, in view of the large scale retirements over the next few years. PSBs would have to increasingly look at performance management, changing mindsets and empowering employees for fast and effective decision making. It requires a cultural revolution in the banking sector, particularly for public sector banks if they wish to retain the competitive advantage of size over the smaller but more nimble footed private sector/ foreign banks. Regulatory / Supervisory Environment 26. One of the essential pre-requisites for attaining sustained growth is financial stability, which in turn requires a combination of strong regulation and supervision. The regulators and supervisors need to be abreast of the changing contours of the financial system, be aware of the changes in the way banks do business, new products and services, the risks and the mitigants. They need to have their ears to the ground, so to speak, so that they are not caught unawares by the undercurrents in the financial system, which could turn into a financial tsunami. Given the tremendous financial and human cost of the recent sub-prime crisis, we cannot afford a relapse. Hence, the emphasis has to be on developing a strong supervisory infrastructure for creating a robust financial system and an environment conducive to growth. We at the RBI have been looking at the supervisory system and the way we supervise banks. Based on the recommendations of the High Level Steering Committee set up for the purpose, we have initiated the transition from a CAMELS transaction based approach to a Risk based approach in supervision of banks. Based on the interactions that I had as the Chairman of the HLSC and other periodic dialogues that I have with the bank management, my assessment is that most of the banks do not have a clear perception of their activity wise costs and profits. It is, indeed, perplexing how these banks have been managing their risks when they do not have an idea of which activity/business line has a positive risk-reward skew? 27. Against this backdrop, as a first step, we have advised banks to re-assess their risk management architecture, culture, practices and such other related processes and to benchmark them against certain essential requirements which have been identified as prerequisites to introduction of risk based supervision. Banks have also been advised to upgrade their HR capabilities with regard to skill sets required for handling risk management systems, MIS, etc. to facilitate the switch over to risk based supervision. RBI would also conduct training programmes/ workshops for banks once the Risk Profile Templates and guidelines on RBS are finalized. Meanwhile, the challenges for banks would remain in terms of upgrading their MIS capabilities, fine tuning their transfer pricing policies, measuring transaction/ activity wise costing, evaluating the risk-return trade off, putting in place an effective and transparent framework for risk based pricing of products and services and non-discriminatory pricing of liabilities. Conclusion 28. To sum up, let me recapitulate the key ponderables: The first and foremost requirement is to improve the Governance standards in all spheres - at the centre, state, institutions, individuals, etc. Probity in public life and in our dealings are key ingredients that can unshackle the chains that bind us. We need to build public opinion/ awareness about the need for rapid growth as it would prove to be the main driver for the changes that we seek. Agitation is not and cannot be a solution. The banking sector has to develop strong linkages with the real sector in order to ensure stable and sustainable growth. This should govern all aspects of banking operations which would help avoid build up of systemic risk through asset price bubbles. We have recounted some of our inherent strengths earlier. All we need is to refocus on our key strengths and to concentrate our energies on overcoming the bottlenecks currently shackling our growth. Collectively, we need to work hard and improve our productivity and efficiency. There is no reason why we cannot realize our potential of being a high growth economy. As stakeholders, let us strive towards attaining a sustainable high economic growth trajectory and making India a vibrant economy where the gains of inclusive growth disseminate wide and deep and touch all lives, especially those at the bottom of the pyramid. Together we can make this happen. 29. I once again thank ASSOCHAM for inviting me to this Summit and giving me an opportunity to share my thoughts on the theme of the Summit. I note that the technical sessions to follow will be focusing on related sub-themes such as financial inclusion, reforms and the emerging regulatory framework. I am sure that the imperatives of productivity, innovation and reforms, along with the need for linkages between financial sector and real sector, which I alluded to earlier, would find resonance in the session discussions. I hope that today’s deliberations would generate new ideas on how to realize the potential of Indian banking and achieve the explosive growth required to support the needs of the economy, as it seeks to regain its high growth trajectory. Thank you. References Report on Trend and Progress of Banking in India 2011-12 India’s Urban Awakening: Building Inclusive Cities, Sustaining Economic Growth-McKinsey Global Institute April 2010 Doing Business 2013 - IFC & World Bank Report Faster, Sustainable and More Inclusive Growth – An Approach to the Twelfth Five Year Plan (2012-17) Indian Banking 2020 - Making the Decade’s Promise Come True - Boston Consulting Group Business Standard, August 18, 2011- India to be $5.6 trillion economy by 2020: Dun and Bradstreet Business World issue dated Nov 19, 2012- Where are the angels? 1 Keynote Address delivered by Dr. K. C. Chakrabarty, Deputy Governor, Reserve Bank of India at the Inaugural Session of the 8th Annual Banking Summit organised by the ASSOCHAM at New Delhi on November 21, 2012. Assistance provided by Smt. Theresa Karunakaran in preparation of this address is gratefully acknowledged.