There
is no doubt that the financial sector in India was generally
much less affected by the global financial crisis of
the past year than in many other developed and developing
countries. This is not to say that Indian finance was
unaffected: there were wild swings in external capital
flows (particularly portfolio flows) as well as in the
stock market. And the credit crunch that was so evident
in September 2008 may have abated for large corporates,
but it continues to plague small producers in all major
sectors. If anything, the lack of financial inclusion
that has been such a major failing of institutional
finance in India has been further intensified during
the crisis.
Even so, the overall resilience of Indian banking is
now the object of international interest. This outcome
is seen to reflect the combination of a relatively cautious
and calibrated approach to financial liberalisation
(reflecting also the political equations that affected
government policy in this regard); the continued presence
and strengthening of public sector banks, which account
for the majority of banking transactions in the country;
and the recognition that in a developing country such
as India banking and monetary policies need to serve
a variety of social objectives.
Obviously, the central bank is absolutely crucial in
all of this. Therefore, much attention has also been
focussed on how exactly the Reserve Bank of India (RBI)
dealt with issues of monetary and capital account management
and financial sector reform in the past five years,
which was a relatively unusual period both globally
and within the country.
Particularly, the role played by the then Governor of
the RBI Dr. Y. V. Reddy, has been widely noted, because
of his judicious approach to various financial liberalisation
measures that were eagerly pushed by some sections of
the Indian establishment. During his five-year tenure,
the RBI displayed what now turns out to have been extremely
effective responses, in terms of strengthening public
sector banks by recapitalisation; preventing some of
the financial ''innovation'' that allowed risk to be disguised
rather than actually reduced; taming the overexposure
of domestic banks to what are now seen as toxic assets
globally; restraining the excessive bullishness of financial
investors in real estate; regulating the activities
of systemically important non-bank financial institutions;
and speaking out against hasty and potentially risky
attempts to liberalise the capital account of the balance
of payments. It also argued (albeit unsuccessfully)
against some practices that continue to be dubious,
such as the Participatory Notes route for portfolio
capital inflows. All these measures stood India in good
stead not only by preventing over-enthusiastic responses
during the global boom, but also reducing the negative
impact of the global slump.
That may be why the Nobel Prize-winning economist Joseph
Stiglitz, who was most recently head of the Commission
set up by the UN General Assembly to examine the international
financial architecture (of which Dr Reddy was also a
member), famously said in an interview to an Indian
television channel: ''If America had had a central bank
chief like Y.V. Reddy, the US economy would not have
been in such a mess.''
Naturally, in such a context, a book written by Dr Reddy
that outlines the important elements of his approach
and describes the challenges of central banking in these
complicated times is of very great interest. In general,
books by central bankers are not known for their readability
or their wider appeal. But this particular book (''India
and the Global Financial Crisis: Managing Money and
Finance'', New Delhi: Orient Blackswan 2009) stands out
as an exception. It is very clearly written, in as accessible
a style as possible given the inevitable complexity
of much of his subject matter. While describing the
experience of the recent past, Reddy makes a number
of points that remain even more relevant today.
The approach outlined in the book is essentially a pragmatic
one, eschewing orthodoxies of either Right or Left and
not falling easily into any definable camp in terms
of policy orientation. The Introduction as well as the
various speeches and articles collected in the book
make it clear that Reddy sees that central banker's
task in an economy like India is fundamentally about
growth, stability and financial inclusion. The latter
is the most important addition, and it is significant
that all three goals are seen to be equally important.
This makes the approach very different from mainstream
ways of looking at central banking, especially the recently
popular paradigm in which inflation targeting was typically
seen as the only goal, with the interest rate as the
sole instrument, while financial markets were largely
left to fend for and regulate themselves.
This approach is elaborated in several chapters that
provide a fascinating account of the dilemmas and policy
choices that faced the RBI in particular episodes, in
what must be seen as a turbulent and constantly changing
domestic and international environment. The difficulty
of trying to ensure that prudential regulations operate
in a counter-cyclical way, given that they have been
designed to be pro-cyclical in effect, is neatly described
- and it remains one of the central issues facing the
Basel Committee today. The problems of identifying which
are the systemically important financial institutions
(both banking and non-banking), and how exactly their
activities need to be controlled, are also clarified
through descriptions of actual decisions made at different
times. The need to curb excessive enthusiasm in introducing
futures markets on an extensive scale within India is
highlighted. The risks inherent in opening up of financial
markets, especially debt markets, to foreign investment,
are identified in what now seems like a very prescient
analysis.
During Dr. Reddy's tenure at the RBI –when the articles
collected in this volume were written – many if not
most of these positions were seen as not just cautious
but also heterodox and possibly even heretical. But
the validity of these arguments has been effectively
underlined by subsequent experience, not only in India
where many of these views prevailed in terms of actual
policy, but in the counter examples of economies where
excessive deregulation and lack of a coherent central
bank strategy for controlling finance were closely associated
with financial crisis.
Reddy does not subscribe to the view that foreign banks
or foreign capital are critical to enabling improvements
in the domestic banking sector, which continues to be
dominated by public sector banks. Rather, in the Indian
case, domestic banks were effectively dealt with and
strengthened through a variety of measures, by easing
some constraints on the functioning of public sector
banks and addressing the problems of vulnerable private
sector banks through capitalisation, mergers and regulatory
rigour. This remains a critical issue since the advocates
of further privatisation and foreign ownership of banks
continue to press for such changes, despite recent international
experience.
The book also provides a valuable insight into how the
approach of the central bank has to change not only
according to various goals that are seen as important,
but also in response to the changing economic situation.
Reddy describes how the period after 2000 witnessed
a move from what had been characterised by ''lazy banking'',
in which banks simply invested in safe securities such
as government bonds even in excess of the statutory
requirement, to what he designates as ''crazy banking''
with an explosion of credit after 2005. This was dealt
with by insisting on additional capital requirements,
because of the uncertainties and risks that seemed to
be emerging. At the time there were those who cried
foul, but there can be no denying that such protection
eventually proved to be of great consequence.
The need for a more financially inclusive policy is
clearly one of Reddy's central concerns, as is only
to be expected given the very poor degree of access
to institutional finance to the bulk of the Indian population
and large parts of the productive sectors in the economy.
Despite some efforts, this clearly remains a major area
of underperfomance, at least partly because microfinance
has been treated as an alternative. Reddy provides a
very interesting discussion on the qualities and possibilities
of microfinance, and correctly notes that the long term
objective should be the financial inclusion of all persons
through the banking system, rather than to have two
separate institutions, micro for the poor and banks
for the rest.
This is an extremely useful book not only for those
involved in finance, but even for laypersons who wish
to understand how the Indian financial system works.
But it is also significant because of the importance
of several of Reddy's arguments for the ongoing debate
on financial sector reform in India. Now that the Indian
government, in an apparently incomprehensible move,
has chosen to take a World Bank loan to recapitalise
public sector banks (even though the banks are generally
perceived to be in good shape financially and in any
case no foreign exchange is required for such a project)
it is likely that many policies such as unnecessary
opening up to foreign capital and allowing greater risk
exposure and financial innovation will be pushed. It
is therefore essential to have cogent and sensible positions
on the need for and the likely impact of such policies,
as identifying alternative strategies for Indian banking
and finance.
So Reddy's book does much more than provide an illuminating
account of central bank policy from the point of view
of a recent practitioner. It provides a reasoned critique
of policies of unnecessary deregulation and highlights
the need for balance and for recognising the requirements
of the development project. While it may not provide
full details, it also sets out the possibility of an
alternative framework that can be applied even in these
more open and externally integrated times, to work towards
the goal of social banking for all.
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