Bitter Truth of Public Sector Banks AND UPA Government

Former World Bank economist Percy Mistry, who authored a widely acclaimed report on making Mumbai an international financial centre, says state-run financial institutions need drastic changes in their working and the government should draw up a strategy to exit these institutions. Edited execrpts from an interview with Dev Chatterjee & Abhijit Lele.

After a lot of time, there is some clarity emerging in policy making under the leadership of the new finance minister… What’s your take on the recent policy changes?

The change in FM was long overdue for policy and GoI/MoF credibility to be restored. India had lost all credibility following prolonged macroeconomic mismanagement between mid-2009 and mid-2012. Thank God PC is back. We seem to be on the right track again. However we are not out of the woods by any means. For example, it was shocking to hear the kind of arguments made during the debate on FDI in retail and on the banking bill. I wonder whether the political class in India at the Centre and in the states is aware of economic realities as they are today.

Somehow the political class in India is still under the impression that they have to indulge in the politics of patronage. There is as yet little debate on the politics of development, governance or the delivery of services. The political class still believes that the Indian electorate comprises a bunch of babies that should be given jalebis at election time. In spite of every election which has shown that the electorate wants development and good governance, over 90 per cent of our political leaders seem proud to remain economic illiterates.

After last year’s anti-investor moves like GAAR, the vendetta conducted against Vodafone, and a series of corruption scams that resulted in reversing many licenses, foreign investors’ confidence and the credibility of the government had been completely eroded. But I have to give credit to the present finance minister and the restored vision of the PM – which seemed absent for too long -- for bringing back investors’ confidence both in India and abroad.

The reality is that without massively increased foreign and domestic investment, both FDI and FII over the next 5-10 years, India will be flirting with another severe economic crisis given trends in our current account and aggregate fiscal deficits. Without such investment growth will remain below 6%. The fragile dynamics of our twin deficits will spiral out of control leading to a debt crisis which will trigger a financial crisis leading to a broader economic crisis.

 People do not realize that we are dancing at the precipice of our own fiscal and CAD cliffs and could tip over the edge quite easily if Parliament does not get its act together and move swiftly ahead with other financial reform bills; especially the pensions and insurance bills that are key to bringing in more FDI and FII with multiplier effects.            

(MY Comment:   After all who are those politicians who may be held responsible for creating such a insurmountable fiscal cliff?---Who are responsible for current fiscal crisis and growing CAD? Who are responsible for abrup rise in bad assets in state run banks?

 It is wrong policies imposed on India in a bid to compete with developed countries without ensuring same level of sound administration, police system , judiciary,infrastructure, education , skill etc as characteristics of developed countries like USA and UK ))

In a few weeks, the government will be coming out with its budget at a time when elections are almost set to be declared. Do you think the finance minister will have enough courage to make bold economic reforms? 

What bothers me is that he seems to have very little room for discretionary budgetary maneuver however hard he tries. And there is no appetite or time for making large and bold changes that we need in tax and expenditure policy. What also worries me is that in spite of a devaluation of rupee from a central level of 45 to 55 against the dollar, it has not had any of the positive impact it was supposed to have on the economy (like increasing exports, a higher level of import substitution and reducing aggregate demand for imports. 

Today India’s imports are still very high and we are still not on track for import substitution. The government should also look at making Gold ETFs more advantageous to small investors. At present there is not much difference on the price between the gold and the ETFs and therefore there is not as much demand for gold ETFs as there should be. 

Clearly we need to do what we can to reduce demand for physical gold and increase demand for paper gold derivatives. Any plans to increase import duties or have quantitative restrictions on gold imports will only encourage smuggling of gold in the country. That will be very difficult to control.

Besides don’t forget the current political scenario. The Congress is on the backfoot on corruption charges and given its performance from 2004-13 it does not really deserve to get re-elected if there is any justice in the real world. The BJP does not have a clear leadership plan and no one knows what it stands for when it comes to economic policy. What we do know it stands for is not very comforting for communal harmony. The third front strategy is not clear at all. Mulayam and Mayawati will always be available to the winning side. But it is almost impossible to see a third front being cobbled together that will have a cohesive and credible national economic policy, foreign policy, defense policy of home policy.

 So I do not see the prospect of the kind of political stability that will provide the kind of comfort that investors (foreign and domestic) need and demand for the next few years… we are heading for either 1986-1991 situation or the 1996-99 situation when politics was so fractured that there was an election every year. I don’t think the finance minister has much space for maneuver in these circumstances. I see all kinds of constraints on him to take big, bold economic reforms measures.

RBI and government are working on giving new banking licenses for bringing more people into banking fold? Does that make sense?

No it does not. The problem in India is not that we do not have a sufficient number of banks. It is that 70% of our banking system is state-owned, inefficient, un-inclusive, and provides the means by which too cosy a nexus between the government and the wrong kind of private industrialists. 

The state-owned banks ( SOBs) and insurance companies (SOIs) together provide the institutional mechanism to foster a dangerous and damaging type of crony capitalism regime in India as well as to indulge in electorally driven loan melas and loan write-offs. . That unfortunate nexus is decidedly kleptocratic in nature when it comes to looting the nation’s natural resources (whether spectrum or mineral or land) through the kind of public-private partnership that India does not need. Moreover the Indian fiscus cannot afford to keep meeting the capital needs of the state-owned banks. And the SOBs certainly do not serve the interests of the poor or the disenfranchised. 

In fact quite the opposite is the case. Any proper cost-benefit study of the performance of state-owned banks would show that the cost of having these SOBs is far higher than the supposed benefits. The same is true of Air India by the way and a jost of other SOEs (or what we call PSUs).

In that context creating new private banks to compete for 30% of the banking pie does not seem to me the answer to the problem of making the banking system more capable, responsible, efficient and inclusive. The answer lies in privatizing the SOBs and SOIs and in giving far more room to foreign banks to enter and serve the Indian market without the extreme restrictions that the RBI imposes on them. Many people will look to the 2008 crisis and say that is exactly the wrong solution for India. They would be wrong and would be looking at the wrong lessons to learn. 

I worry that many of the new licenses will be given to unfit and improper persons that are politically well-connected rather than potential bankers of judgment and probity. Look at the line up (of those interested in opening banks) and you would need to worry about the “fit and proper test”.

The problem is not also with how many banks we have. Many new banks were set up when RBI gave licenses in two rounds. Apart from Axis, ICICI and HDFC, there are no other solid private banks that have emerged as stronger or better.

In my view as long as Indian banking is dominated by SOBs we will not achieve any of the objectives of the banking system reform that we so urgently need.

What about giving licenses to industrialist to open new banks? 

Although many in India regard me as the prime ayatollah of market fundamentalism I do not think large industrial houses should be allowed to run banks. There will be massive scope for malfeasance. It is only in Japan and Korea that industry/trading houses (zaibatsus and chaebols) have got banks under their vast and diversified umbrellas. Japan is still struggling with the two decade old financial crisis. It is when ownership of banks is distinct from that of industry, media and services that the economic and financial systems work best.

Banking space is dominated by state-owned banks in the name of serving public interest? 

We in India refuse to accept that the state-owned banks (SOBs) and SOIs are not our strengths but our greatest weakness. They are transmission mechanisms through which government encourages crony capitalism, and entrenches its economic power. 

If India was transformed after the 1991 reforms -- which in the light of recent history should be more appropriately referred to as the Narasimha Rao reforms than the Manmohan Singh reforms —it was because those reforms put some space and distance between our political system and the economy. 

Where we have malfeasance, corruption and inefficiency it is directly correlated to situations where that space between politics and economic remains too narrow. The SOBs and SOIs bridge that space between politics and economics and diminish India and its prospects by doing so. 

We have 18 public sector banks and one SOB (SBI group) that accounts for 25 per cent of market. Punjab National bank, which should be a pan Indian bank, is only strong in the Northern region. The FM should seriously consider privatizing all the SOBs other than SBI and PNB for the time being and examine the impact of that experiment.

And all the evidence suggests that the one thing that SOBs and SOIs do NOT do is serve the public interest. They serve the interests of their managements, staff, the public sector employees unions and of central and state governments that can exert influence over economic agents through them. SOBs and SOIs are our greatest source of systemic risk.

In India there is a huge hue and cry for financial inclusion? Is that a good thing?

A) That is partly so since state-owned banks are so dysfunctional and they do not work. All this euphemistic talk of expanding financial inclusion in India terrifies me. It is one factor which led to the global financial crisis in 2007-08 when Greenspan thought that the idiotic things that US banks were doing – by lending Mexican gardeners multiple mortgages at 130% of home value and classifying these loans as being made to ‘landscape architects’ -- were great in the name of financial inclusion. Mexican gardeners were being included in the wealth chain of California, Arizona, Colorado and New Mexico. Now we can all see what that led to.

It is not as if we have not tried inclusion before in India. Only then we called it agricultural and rural credit. The banking system has taken massive repeated losses with that type of lending. That has also been the experience of most developing countries around the world. That is not because farmers and rural dwellers are fundamentally untrustworthy. It is because they are poor and exposed to risks they cannot manage.

It is one thing to say we want to introduce more people to the formal payments and settlement system that banks provide. That is all to the good. But, I would be terrified about extending credit through the public banking system to the fundamentally uncreditworthy. It is not that they have bad intentions. They are affected by many vagaries and risks that are out of their control and they do not have the savings or income to manage.

What we need instead of issuing new banking licenses is a clear strategy on how the government exits from state-owned banks. The other institution that I have become very worried about is the Life Insurance Corporation of India (LIC). It is has become the largest institutional investor in the Indian economy and it functions in a manner that is not entirely publicly accountable, transparent or clear. Its investment decisions and their timing are a mystery to me and most others. Sometimes they seem to be driven more by political rather than fundamentally economic or cyclical decisions.

Given the way our state functions, it worries me. For me, real systemic risk in the Indian financial system is probably caused by the LIC and the state-owned banks.

You must have seen in most of the disinvestment program, LIC becomes an unofficial underwriter for the government? 

It is not a disinvestment program. It is simply moving assets of from one side of government ownership to another side. The camouflage fools no one. In my view it is time to end all this nonsensical babble about disinvestment for reasons of political correctness. India does not need to proceed with creeping disinvestment. To secure its economic future it needs to proceed on a large scale with sensibly planned and phased privatization. Frankly I fail to see why anyone wants to buy shares in Indian SOBs or SOEs that are controlled and managed by government ministries and ministers. Time and again political decision-making and social policy intrudes in these organizations in what should be entirely commercial decision-making.

In effect, what you are doing with the failure of our disinvestment policy to attract private investors is shifting responsibility for ensuring good corporate governance, SOE accountability and transparency from the ministry concerned to an institutional investor like the LIC. What does that achieve?

No one is asking questions to LIC? 

A) In that context I think that the IRDA Chairman was absolutely right in opposing lifting the investment ceiling for LIC from 10% to 30% in any single enterprise and the MoF was entirely wrong to ignore his advice and force the issue for the sake of expediency.

Is it transparent enough? 

It is an extremely opaque. In fact, that is true of the entire public sector insurance sector. They are not required to report on actuarial risks by tenure or by sector.

It will be very nice to see if someone poses question to what degree LIC pose systemic risk to Indian financial system.

Supposing, the market for whatever reasons were to fall from current level of 19,500 to 15,000 what kind of hit would LIC take on its capital. What happens to its provision reserves? Would we simply say we will not mark-it-to market, which we always do?

LIC should be privatized. It is not just insurance company but also the largest asset management institution in India. But no-body regulates it properly either as an insurance company or as an AMC. I do not see at all IRDA being able to regulate LIC effectively. It is regulated by MoF under the LIC Act. That creates a distinctly unlevel playing field in the insurance sector.

How can you justify impartial arms-length regulation when you do not have a level playing field. The largest insurance company and asset manager is regulated under its own act. IRDA only regulates only 30 per cent of market (private insurers) and no-body asks serious questions about the other.

That is also true in some senses of banking regulation by the RBI. We have three-tiered regulation there as well. In our regulatory system the SOBs are favoured and protected. The private domestic banks are regulated in more draconian fashion and the foreign banks are throttled not regulated.

http://www.business-standard.com/india/news/new-banking-licences-make-no-sense-percy-mistry/497904/