Saturday, May 16, 2015

The problems of financing and the elusive recovery in the Indian business cycle

The pre-crisis credit boom and its consequences in the post-crisis period is a key feature of understanding what ails the economy today.

The pre-crisis credit boom

In Y. V. Reddy's period as governor (6/Sep/2003 to 5/Sep/2008), there was vigorous pursuit of exchange rate policy. In an attempt to defend the dollar, RBI purchased a lot of foreign assets and paid for this using rupees. These rupees distorted domestic monetary policy. At a time of the biggest ever business cycle expansion in India's history, RBI engaged in loose monetary policy. This gave the biggest ever bank credit boom:

Year-on-year growth of bank credit ("non food credit")

Central banks are supposed to take away the punch bowl when the party gets going. Instead, RBI laced the punch bowl when the party got going. Exchange rate policy converts the pro-cyclicality of capital flows into pro-cyclicality of monetary policy.

If we encountered the same combination of events today, would things work out better? One part of the problem has been partly addressed but the second has not. At the time, RBI had no clarity of objective, so each governor could make up his own objective, and the objectives could keep changing from day to day, without transparency. Y. V. Reddy had decided that his objective was the exchange rate. We are now on better ground: RBI now has only one objective -- CPI inflation -- and is held accountable for it and this choice of objective is no longer under the control of the governor. By taking away the discretion of the Governor, we have made RBI a more effective institution. However, we have yet to see the extent to which RBI works within the Monetary Policy Framework Agreement.

A second line of defence is systemic risk regulation. If there had been a systemic risk regulator in the country at this time, they would have seen this credit boom. The first trick in the mind of a person in the field of systemic risk is to watch out for big credit booms led by bank lending. This would have generated pressure to take countervailing actions. On this front, as yet, we do not have progress: there is no institutional capability in India which engages in systemic risk regulation. The draft Indian Financial Code envisages that FSDC will be the systemic risk regulator, but this institution has not yet been constructed. See this previous blog post on the strategy for systemic risk regulation.

The problems of banks

Finance is the brain of the economy, but in India, banking works badly. Weaknesses of regulation and supervision have given difficulties in the thinking of banks. With the low knowledge about banking at RBI, in India, a credit boom generally implies that credit goes into the wrong places.

A lot of the increased credit of the pre-crisis credit boom went into the wrong places. While most firms in India today are reasonably healthy, perhaps a quarter of the balance sheet size of Indian firms is in significant distress. These firms have low earnings, and are finding it difficult to handle their debt. The banks that have lent to them are also, consequently, finding that the going difficult. Some people look at overall statistics about Indian firms and draw comfort. But what's important here is not a measure of location but the left tail. If 25% of corporations are in trouble and that hampers investment by 25% of the firms, that still generates a financial channel for business cycle fluctuations.

As with past business cycle downturns, RBI's strategy has been to support banks in hiding the bad news. This postpones the bad news but does not solve the problem. As is well known in the international experience with banking distress, the countries that confront problems are better able to bounce back into safe and sound banking. When a banking regulator works to hide bad news, and supports zombie banks, this gives a Japanisation of banking, with a slow lingering crisis that hurts for years and years.

We are seeing two kinds of unwillingness to give out loans in Indian banks today. Some banks are able to discriminate good borrowers from bad borrowers and shun the weak ones. Most banks see trouble on the horizon and are holding back on all lending. They are just putting their money into government bonds. Let's zoom into the latest 3 years of the graph above, of the growth in non-food credit of banks:

Year-on-year growth of bank credit ("non food credit") for the latest 3 years

The graph above shows the substantial drop in year-on-year growth of bank credit that's afoot. To some extent, this is about the decline in inflation. But this is also about the combination of difficulties in the economy (that hamper demand for credit) and difficulties in banks (that hamper supply of credit).

Implications for macro and finance policy

This perspective has a major impact upon our thinking on macro and finance policy. When the BJP government came to power, this should have played a big role in thinking about how to play things. As an example, see this column in the Economic Times on 12 February 2015. It suggests:

  1. Formal inflation targeting at RBI.
  2. Setting up PDMA and phasing out financial repression.
  3. Enacting the Indian Financial Code to do consumer protection and properly regulate long-term contractual savings.
  4. Setting up the Bond-Currency-Derivatives Nexus, drawing on the success of the equity market.
  5. Fixing the capital controls for rupee bond inflows and
  6. Reforms of NPS, EPFO, and other long-term savings mechanisms.

How did we fare in the period after 12 February? There is some progress but not enough to solve the problems.

  • We got an inflation target but RBI managed to stave off the sound institutional machinery of a properly constructed monetary policy committee.
  • The PDMA and the bond market reforms were rolled back so we have nothing there. See P. Chidambaram in the Indian ExpressVivek Dehejia in the Mint, and Tarun Ramadorai in the Mint.
  • Capital control reform took place with an important amendment to Section 6 of FEMA. But regulation-making power for debt remains with RBI so there will be no progress on that part.
  • Portability between EPFO and NPS is a good step forward (though a lot rests on how frictionless the arrangement is). But a spectre is now haunting the NPS, the spectre of defined benefits. This could damage the core principles of NPS, of thrift and self-help.
  • The Finance Minister has made commitments about bond market reform (shifting the BCD Nexus from RBI to SEBI), setting up the PDMA, and tabling the Indian Financial Code in Parliament. But these remain actions at unstated future dates.

A great wave of entry of private and foreign banks would have helped bring new energy into banks, thus augmenting the flow of bank credit. But we remain stuck with the silliness of giving out only 2 new bank licenses per decade and blocking the expansion of foreign banks. Short term improvements can be made in the working of Asset Reconstruction Companies, and thus give a bit of improvements on de facto bankruptcy process. Instead, RBI is going in the opposite direction, favouring restructuring and deferring early resolution.

Yesterday, Neelasri Barman and N. Saraswathy, writing in the Business Standard, talk about bond issues by firms which failed. While this is partly about unexpected developments in the global bond market, this is also about the deeper problems of macro and finance policy that are holding back the macro economy.


Arun Shourie has emphasised the problem of too much tactics and not enough strategy, that afflicts the Modi administration.

For many years now, Josh Felman has emphasised the importance of the pre-crisis credit boom, and its downstream implications for busienss cycle conditions. The rich interplay of finance and macro is a key element for thinking about what ails the economy today. This perspective should have a major impact upon the strategy for macro and finance policy.

Perhaps 25% of the required work has been done through the Finance Act, 2015. The bulk of it has not been done. The lack of strategy in macro and finance policy is hampering the economic recovery. There is a need to put MOF, RBI and SEBI on the right track to go after these problems.

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