Integrating Financial Markets Through MUDRA

Why the MUDRA Bank is necessary and what shape is it likely to take. Last week, Prime Minister Narendra Modi launched the Mudra (Micro Units Development and Refinance Agency) Bank amid much fanfare.  Mudra Bank, focused on small and micro enterprises, will facilitate credit by refinancing financial institutions for lending to micro businesses and entrepreneurs covering loans from Rs.50,000 to Rs.10 lakh. It will also act as a regulator for micro-finance institutions (MFIs).The initiative has attracted quite a bit of criticism and skepticism, but these do not understand the scope and possible structure and even the context in which the Mudra Bank became a necessity. That context is the extreme difficulty that small and micro enterprises face in accessing credit.

The government has itself admitted that only 4 per cent of the 57.7 million small business units have access to institutional finance. This is true and unfortunate. The Prime Minister speaking at the launch of MUDRA. Unincorporated enterprises comprising proprietorship and partnership firms account for close to 50 per cent of India’s gross domestic product (GDP) and an almost similar share of value addition in the manufacturing sector.  They also constitute almost 70 per cent of enterprises in various segments of the service sector, which has a nearly two-third share in GDP and has been averaging an 8 per cent growth in the last decade. Trade, which is part of the service sector, itself, is nearly 17 per cent of GDP, as much as manufacturing. In spite of playing such an important role in the economy, the credit available to unincorporated enterprises from formal banking channels is actually shrinking. Industry experts estimate that the demand for loans from the sector outstrips the supply by more than Rs 30 lakh crore.

Consider these numbers. Between March 1990 and 2012, the share of the household sector in national income [consisting of unincorporated or small and micro units came down from 58 per cent to 36 per cent. Ironically, it was during this period that the role of the unincorporated enterprises in trade, transport, construction, restaurants, and other business services grew at more than an 8 per cent compounded annual growth rate (CAGR). In contrast, the private corporate sector, whose share in national income, is between 12 percent and 15 per cent takes away nearly 40 per cent of the credit provided by the banking sector. Let us look at another set of figures – outstanding credit of scheduled commercial banks. In the up to Rs. 10 lakhs category, the share of credit outstanding has come down from 32% of total credit outstanding in March 2000 to 21% in 2011. Even if one increases the credit limit range to up to Rs 1 crore, the share has fallen from 45% to 32% over the same period. This is not just lazy banking but also banking with significant structural distortions. With the formal banking sector failing the unincorporated sector, the latter has little choice but to rely on the non-banking financial sector. This is an assorted group of entities which include unincorporated bodies or money lenders, chit funds and nidhis andkuris.

Consider yet another set of figures. At Rs 13.5 lakh crore, the share of trade in national income (at factor cost at current prices) was 18 per cent in 2011-12. Of this,the share of the non-corporate sector was nearly 76 per cent, or approximately Rs 10.1 lakh crore. If 75 percent needs to be financed (which could be an underestimation since we are looking at value addition and not sale), then the credit need of the trade sector is Rs 7.6 lakh crore. However, according to the Annual Report 2012 of the Reserve Bank of India, the financing of trade by the banking sector was Rs. 2 lakh crore  in 2011, which was 28 per cent of the credit availed by the sector. So, more than 70 per cent of the financial requirement of the non-corporate sector in trade is met by non-banking sources.

The transmission mechanism of our monetary policy is weak due to the segmented market. This brings out the need to have a comprehensive approach towards the non–bank sector in the credit market instead of looking at issues in a piecemeal fashion. Generally the interest rate for unincorporated enterprises varies from 2 per cent to 6 per cent a month, depending upon the requirement and speed of getting credit. So we have a situation of huge funds available with the formal banking sector, on the one hand, even as the non-corporate sector is forced to borrow at prohibitive interest rates from the non-banking sector. What is really needed is a comprehensive approach towards the non-bank sector in the credit market instead of looking at issues in a piecemeal fashion. Currently, different entities under the broad rubric of non-banking companies are regulated by different agencies. Unincorporated bodies are regulated by state governments, chit funds by the registrar of chits of state governments and nidhis by the department of company affairs of the Union government. The stress is more on regulation rather than on development of an integrated financial market.

This is where Mudra Bank can play a role by integrating the large number of individual money lenders and other micro/mini financial bodies into the main financial markets. Remember, Mudra Bank is not a regular lending bank. It will formulate lending norms and responsible financing practices for micro-finance institutions so that the small businesses do not face hardship over indebtedness, while getting a fair environment for repayment. It will facilitate credit of up to Rs 10 lakh to small entrepreneurs, benefitting small manufacturing units, shopkeepers, fruits and vegetable sellers, hair saloon, beauty parlors, truck operators, hawkers, artisans in rural and urban areas – the very sectors that get a raw deal from the formal banking sector.

 Providing access to institutional finance to such micro/small business units/enterprises will not only help in improving the quality of life of these entrepreneurs but also turn them into strong instruments of GDP growth and employment generation.  The initial products and schemes under this umbrella have already been created and the interventions have been named ‘Shishu’, ‘Kishor’and ‘Tarun’ to signify the stage of growth/development and funding needs of the beneficiary micro unit/entrepreneur. However, it is not yet clear if Mudra Bank will emerge as the sole regulator of the micro-finance sector, replacing the Reserve Bank of India, which regulates MFIs that are registered as non-banking finance companies (NBFCs). A decision on this will be taken when the bill on Mudra Bank will be drafted. Till the Mudra Bank gets statutory status through an Act, it will be a subsidiary of the Small Industries Development Bank of India and will be registered as an NBFC.

The Mudra Bank can be different from existing systems if it will be more relationship-based and not just rule-based. It should involve less paper work, enabling easy accessibility to finance. In addition, it should deal with cash flow-based lending rather than asset-based lending. After all, most of the target borrowers are in the service sectors and hence the need to focus more on income generated rather than fixed assets etc. The lending institutions are expected to be less rigid in terms of risk adjusted capital/NPA provisioning etc and will encourage technology-based collection mechanisms for ease of transactions. The Mudra Bank can become a vehicle for integrating the currently segmented and disparate financial markets. It needs to become a Small Business Finance and Development Authority (SBFDA), with the authority to register, develop and regulate small business finance institutions and be fashioned on the lines of the National Housing Bank. This SBFDA will be initially owned by the nationalized and private banks to the extent of 51 per cent with the central government holding the remaining 49 per cent stake. It must have the right to offer shares to foreign institutions through their funds floated for financing small businesses. The SBFDA will also float long-term bonds to augment funds from banks and foreign sources.

MUDRA may formulate guidelines for minimum capital for Small Business Finance Institutions (SBFIs) and also capital adequacy norms for all SBFIs, frame rules for new SBFIs that come up as well as for the migration and registration of all existing SBFIs under the new law. What will be needed is a new definition of small business. Under the new regime, the term small business will include manufacturing, trading and services by sole proprietors, family concerns and partnerships, including limited partnerships and one-person companies within the meaning of the Companies Act. This definition is more appropriate than one based on assets/investments/turnover, which invariably lead to companies splitting after they reach a certain size. Small business finance will mean extending finance to small businesses by way of term loans, working capital, venture capital and other means.

There will be different kinds of SBFIs that will come under the umbrella of Mudra Bank as SBFDA. They can apply for registration with the SBFDA, within a certain period – say, 180 days – of the coming into force of the new law and be subject to the rules and regulations set by it.–SBFIs: These are institutions promoted for and engaged in providing small business finance. More than 60 per cent of their average loan and credit portfolio will consist of small businesses. SBFIs will include all existing non-banking finance institutions including chit funds, unincorporated business and other traditional institutions which satisfy the criteria of small business finance.- National Small Business Finance Institutions [NSBFIs]: Small business finance institutions with operations in more than one state and which are engaged in providing small business finance directly to SBFIs or act as wholesale funding institutions for other small business finance institutions. 

Existing NBFCs which provide finance for small businesses may migrate to the new regime and get registered as NSBFIs as well,  with the proviso that small business finance must comprise 60 per cent of their loan and credit portfolio within a period of three years, failing which their registration will be cancelled.–State Small Business Finance Institutions [SSBFIs]:are existing NBFCs which are engaged in providing finance to small businesses either directly or act as wholesale funding institutions for other small business finance institutions but operate within a particular state. They can migrate to the new regulatory regime and get registered as SSBFIs. They can also get registered as NSBFIs.–Other Small Business Finance Institutions [OSBFIs]:These will comprise all SBFIs, other than NSBFIs and SSBFIs, which operation in parts of any state. In addition to registering these SBFIs, the SBFDA can set norms (including deposit insurance conditions) for NSBFIs and SSBFIs to access public funds by way of deposits and bonds without issuing advertisements or otherwise soliciting subscriptions.

To integrate existing lenders, there is need to undertake a massive survey-cum-rating exercise involving state-level NBFCs and further lower-level financing entities. This will bring orderliness and inclusiveness into the new financial architecture. The process of rating all these entities will enhance credibility and help in risk assessment. This will reduce the cost of lending to some extent. All in all, this refinancing/rating/regulating body will reduce cost of capital and integrate the currently segmented financial markets. The process of funding the unfunded, results in the existing last mile financier being made a part of the system. Let us hope the coming bill fulfills our expectations.

Don’t Rush Into Full Rupee Convertibility

Based on the experiences of various countries, India will have to put in place adequate safeguards. Full rupee convertibility is a great idea, but its time is yet to come. What has prompted first the Reserve Bank of India (RBI) Governor and subsequently the Minister of State for Finance, Jayant Sinha, to suddenly flag off, at this stage of India’s economy, the issue of capital account convertibility is not very clear. Indeed, for the past several years, our policy makers have been struggling to contain inflation, put fiscal consolidation back on track, strengthen the banking and financial system and build up sufficient foreign exchange reserves to deal with any eventuality of volatile capital outflows. In the meantime, the minister is making the case for full capital account convertibility on grounds that it is needed “if India wants to be a global economy”.

However, neither a new policy format nor a time frame is indicated for this. The RBI Governor is reported to have said that “we hope to get full capital account convertibility in a short number of years.” India has progressively moved towards full current account convertibility, which comprises of external transactions on the current account – namely, payments and receipts for imports and exports of goods and services as well as similar transactions on invisible account like services. Over the last two decades, significant progress has also been made in the area of capital account convertibility.

Thus, within certain sectoral limits, all capital inflows, including foreign direct investment (FDI) are fully convertible. Likewise, under the Liberalized Remittance Scheme, all resident individuals are now allowed to freely remit up to US$250,000 annually for any permissible current or capital account transaction or a combination of both. This calibrated strategy towards rupee convertibility on both current and capital account has been widely commended internationally. In particular, this enabled our economy to combat the adverse fallout of the Asian Meltdown in August 1997 as well as of the Global Financial Crisis in 2008-09. It needs to be recalled that during both these events, occurring in a span of just over a decade, extreme volatility of capital flows aggravated the economic crisis in many countries. Thus, the international community, including the International Monetary Fund (IMF), came to refocus its attention on the risks of open capital account, particularly with respect to short-term flows and its implications on the health and stability of the financial system in emerging markets like India.

Pre-Conditions for Capital Account Convertibility What, then, are the essential building blocks for full capital account convertibility? And how soon can we aspire to achieve them? Various expert committees have, from time to time, recommended certain basic norms which need to be fulfilled for moving towards full convertibility. These include:– Sustainable fiscal management (fiscal deficit to GDP ratio firmly reined in at 3 to 3.5% of GDP);– Financial stability manifesting in healthy banking – with sound capital structure (i.e. healthy capital adequacy ratio), manageable non-performing assets (NPAs), 100 per cent marked-to-market valuation of banks’ investments, etc;– Rigorous inflation targeting (a desirable inflation rate ~3%);– Sound exchange rate management – a neutral real effective exchange rate or REER band (+/- 5%) to be monitored by the RBI; and– Control over short-term external debt, reduction of the external debt service to total export earnings (goods & services) ratio from 25 per cent to 20 per cent , forex reserves to be not less than six  months’ imports, etc. Where are we with respect to such rigorous standards? India is delicately poised in most of these areas. Take the case of the latest Budget. Given the tight fiscal position, Finance Minister Arun Jaitley has been compelled to phase out his commitment towards fiscal consolidation over a longer time horizon, with the target of fiscal deficit of 3% of GDP being achieved now only in 2017-18.

Second, in terms of the recently signed Monetary Policy Framework Agreement, the RBI has to stay focused on gradual and durable disinflation in the economy, with a medium-term consumer price inflation (CPI) target of 4% (+/- 0.2%). Over the past three-odd years, with a stubbornly stiff monetary policy stance, the RBI could tame CPI inflation to its current level of 5.2%. But still, these are uncertain times. Going forward, this effort needs to be sustained around the crucial mid-point of 4%.

Third, our banking and financial sector is in the midst of significant transformational changes. The next two to three years are going to be crucial, with the emergence of a whole set of new banking institutions, be it payments banks, small finance banks, postal bank or a more vigorous foray into mobile/ digital banking. Even the existing banking institutions are going to see tremendous changes with their consolidation, restructuring and new business orientation. At a time when this mainstay of full rupee convertibility is being reformed, the policy makers would have to be extra cautious in pushing ahead the patently aggressive reforms agenda of full capital account convertibility.

Lastly, in the global context too, there is a series of risk factors. While reflecting on the World Economic Outlook, the latest IMF report points out that, apart from significant upside risk from oil prices and intensification of geopolitical tensions, “disruptive asset price shifts in financial markets remain a concern…triggers for turmoil include changing expectations about these elements as well as unexpected portfolio shifts”.

Equally significant are the RBI’s own concerns in its latest monetary policy. Thus, it highlights growing risks associated with [a] record high asset prices in many economies on account of “ultra-low interest rates and reduction in risk premia”; [b] high portfolio flows to emerging market economies or EMEs (including India), and the possibility of sudden shifts in market sentiments; and [c] large and volatile movement of exchange rates, especially the sharp strengthening of the US dollar. This is quite apart from the RBI’s persistent apprehensions about the emerging inflation scenario in the country.

A Fascinating Policy Proposition, But…What transpires, therefore, is the fact that full rupee convertibility may be a fascinating policy proposition, and its implementation would perhaps unleash many growth opportunities associated with globalization and a maturing modern economy for India. Even the IMF, which, prior to the 1997 Asian Meltdown was so vigorously pushing countries to move towards full capital account convertibility, has been extremely cautious on this score in recent years. Hence, based on the experiences of various countries over the last decade or more, India will have to put in place adequate safeguards – and all those have been reiterated by various expert committees from time to time. But somehow, we have missed out both on the sequencing of those major milestones and in accomplishing their substantive desirable outcomes. The message is clear: full rupee convertibility is a great idea, but its time is yet to come.

“The Indian tax system needs a complete overhaul” – S Mahalingam

In India, no impact assessment is carried out before changing tax laws, says S Mahalingam, member of the tax reforms commission Indian taxpayers have a litany of woes to relate about the tax system, ranging from arbitrary tax demands and high-handed behaviour, to complex and vaguely worded tax laws. Firms have also been complaining about rising instances of ‘tax terrorism’ which have rendered the country unfriendly to business. It was in this backdrop that the Tax Administration Reforms Commission (TARC), headed by Parthasarathi Shome, was constituted in August 2013. The committee had suggested far-reaching changes for a customer-focussed tax regime in India. S Mahalingam, a member of the Commission and former CFO of Tata Consultancy Services, spoke at length to Business Line on the impactful report.

Excerpts from the interview:

One of the fundamental changes suggested in the report is the abolition of post of Revenue Secretary. You recommend that the powers be vested with the CBDT and CBEC. Why?

The Revenue Secretary usually comes from the civil services and thus brings with him little experience or familiarity with tax laws and administration, particularly international practices, which are increasingly central to tax policy. Yet he finally signs off on all the key policy decisions of the department. Usually, he tends to focus on the administrative aspects, rather than modernising the tax system. To oversee the tax administration, we have instead suggested a Governing Council to oversee the two Boards, with representatives from the industry as well.

Our interactions showed that there is phenomenal capability within the tax department on policy formulation. Good policy cannot be formulated without analysis and experience. This cannot come about if you rotate officers arbitrarily every three years. Tax officers must be allowed to develop specialisation in their respective fields. There is a need for augmenting their decisions with data. So we are not just against generalists at the Revenue Secretary level, we are against them at all levels.

The report strongly criticises aggressive revenue forecasts made in the annual Budget, which are often missed. It notes it is the unachievable targets set for tax officers that often results in ‘tax terrorism’. How can this be addressed?

When you formulate policies that affect so many taxpayers, they need to be backed by rigorous analysis of data. But such analysis seems to be completely absent in India. No impact assessment is carried out before changing tax laws. Nor is there any assessment of costs or benefits after the change is implemented. This is a key reason why the tax system completely lacks customer focus.

Take the simple case of tax projections which are made each year in the Budget. They are often unrealistic. Yet this becomes the target which percolates down the department. In March, the department holds back refunds due to taxpayers or calls them up asking for higher advance tax payments. This is quite a flawed approach to tax collections. Yes, you may be meeting the number, but at the expense of taxpayer interests. Tax projections need to be backed by analysis. If you are assuming a certain tax buoyancy based on a certain GDP growth, it is necessary to go back into the components of that GDP growth to see if the projections are realistic. If it is agriculture which is contributing to growth in a specific year, that will not lead to tax buoyancy. But today, such projections are made without really using the rich data that is available with the tax department because there is no systematic data warehousing, data mining or people who can ask the right questions. Therefore, tax projections end up looking like simple excel sheet forecasts, backed by no real data.

While India has just 20 people engaged in analytics in the tax department, the UK has 400. There is a great need for capacity building in this area. We have advocated a Tax Council to help in formulation of tax policy and related legislation, to be headed by the government’s Chief Economic Advisor. We have suggested the setting up of a knowledge, analysis and intelligence centre which can help in forecasting, data analytics and research.

TARC has recommended a merger of the CBEC and CBDT functions, especially for large taxpayers. Given that one deals with transactions and another with income, what are the

synergies between the two?

The separation of the CBDT from the CBEC is essentially an artificial distinction. Combining the two can lead to generation of rich sectoral data which can be used to formulate better tax policies. Globally, most countries have unified their direct and indirect tax regimes, so that they can be treated holistically as ‘business’ taxes. Sharing information on businesses can lead to higher tax collections. It will ensure people don’t make arbitrage out of information asymmetry. We found that a GST pilot project in Maharashtra which put together the CBDT and CBEC databases to generate comprehensive profiles, helped collect ₹500 crore of VAT from traders who evaded it.

India’s low tax base has been a long-standing problem. Why is it that initiatives like tracking high-value transactions or insisting on PAN cards for more transactions have not worked?

True. Take direct taxes, for instance. While direct tax collections have increased by over 700 per cent in the last ten years, the number of taxpayers has only increased by 35 per cent. The taxpayers in the lowest income slab of up to ₹5 lakh make up 98.3 per cent of the total taxpayers. They contribute only 10 per cent of the tax revenues. This suggests that the tax base is extremely narrow. This has to do with systematic data capture and monitoring. To give a simplistic example, if I am running an organisation like TCS, which has 3.5 lakh employees, I need to know three things. How many employees have attended office today? How many are productive? And how many are getting billed? If I don’t know these basic things, the organisation cannot function effectively.

The tax department needs a similar framework. If there is a high value transaction taking place that should lead to the right questions on who were the parties involved, what the value was and what were the taxes paid. The TARC did a simplistic analysis to say it is possible to increase the tax base to 6 crore from the present 3.5 crore. But this is not easy. You need a holistic system-driven approach to drive the expansion in tax base.

Why is there a continuing disconnect between what the government says and what the tax department does? For instance, this government did make an assurance that it would not act on retrospective tax amendment. Yet Cairn India has been slapped with a retrospective tax demand.

Retrospective tax demands are undesirable. But this can only be explained by the pressure to generate revenues. There is a genuine need to fund India’s welfare and infrastructure programmes. And if the fiscal deficit targets are not met, and borrowings get out of hand, you are essentially mortgaging the future to fund the present. But to generate revenues, leakages have to be plugged systematically and you need to plan how you will meet your revenue targets. To give a reassurance on ‘no retrospective taxation’ when alternative revenue sources haven’t been found, is not realistic. This is why there is a need to think through revenue targets more carefully. To cite one instance, transfer pricing officers in India are given tax targets! Now, a transfer pricing officer is meant to basically avoid evasion and clarify rules on transfer pricing, by deciding where the value addition in a business is happening. Once you give him a target to meet, he is bound to take the most extreme position. So if you simply take last year’s revenues and increase it by X percentage, it is not an appropriate way to set revenue targets. This leads to unhealthy practices, litigation and when the Court rules against you, you again resort to another spurious amendment.

The report flags the problem of in fructuous tax demands, stating that the Indian tax department has one of the worst recovery records in the world. Why does this happen?

Indian tax laws tend to be loosely drafted and open to interpretation. This is because you don’t have specialists drafting the law. Moreover, tax changes are often done in a hurry with little or no analysis or impact assessment. That is why it is critical that the tax department acquires the specialisation to draft the law. Specialisation will help the department win more cases too. Currently, the tax department also often loses out, not because their case is per se weak, but because the assesses can often hire specialist lawyers who fight the case for years. Whereas, departmental lawyers keep changing and the tax officer who is familiar with the case may be transferred too. The dispute resolution mechanism needs to improve too; the department must engage with the assessee before the issue is taken to the Courts.

Corruption is an often cited complaint with the department. Would curbing the discretionary powers to the assessing officer help?

There is bound to be some discretion. But if your administrative systems are working very well, it is possible to reduce the face-to-face meetings between tax officers and taxpayers. This can reduce corruption. Systematic handling of them through dispute resolution centres can also reduce opportunities for corrupt practices. Ultimately, it is very difficult to discourage a person who wants to be corrupt, but you can reduce the number of avenues and enhance systemic interventions. When talking of corruption, the role of vigilance also has to come under scrutiny. For instance, we met an honest officer whose career was ruined for 15 years, because of charges that were never proved. The investigation just goes on and on and the file never gets closed. Corruption cannot be brought down by vigilance alone, you need analytics too.

Why has the simplification and rationalisation of the tax structure come to a halt in recent years? Instead of fewer slabs and exemptions, we seem to be adding on more slabs, more surcharges, cesses and more complexity.

If we had a large tax base, a simpler system can be administered. But we don’t, so revenue pressures force the government to tap as many sources as possible. What we need is impact analysis. After any new tax is imposed, if we had an evaluation of the impact on revenues vis-à-vis compliance costs to the taxpayer, we would be able to eliminate taxes that don’t work. But because there is no such assessment, taxes that have no business to exist continue for years, even as new taxes get added. This is what the Tax Council can

look at. It can bring in the business perspective that is essential to evaluate such measures.

TARC’s report is an unusually detailed and comprehensive report. But usually there is a tendency to cherry-pick recommendations from such reports and implements them partially. What would be your comment on this?

If you want to get rid of tax terrorism, you have to fundamentally transform India’s tax administration. You cannot do it through incremental changes. To cite an example, to reduce disputes, you cannot simply create more posts of full-time commissioners in the department. You need to analyse why disputes arise, create dispute resolution mechanisms and frame the laws in a more water-tight manner. If you do not approach it in that fashion, you cannot succeed.

The importance of the people aspects, brought out in the report, cannot be over emphasised. Our interactions showed that the tax department has completely lost its spirit. It needs to be restored. As one senior officer told me: “If you are mistreated by your employer, how will you deal fairly with the taxpayer?” To me, that did seem to have the ring of truth. Tax officers need to be better equipped through training, empowered by their boards and given the ability to build expertise and specialisation. Finally, you need to get out of this system of setting unhealthy revenue targets which are not based on reality. To do this, you need effective ICT use and powerful analytics. On collections, you should not be wasting your resources going after people who are already compliant. You need to go after people who are sitting on the fence.

What we have suggested is a complete systemic overhaul of the tax administration. Mere tinkering will not be enough. We have not stopped with recommending changes alone. We have also outlined the manner in which you can bring about the change. We have outlined the need for immediate action and created timelines for achievement of different objectives. We also travelled across India to talk to tax department officials to get their feedback to the report. This is a unique report, in my view, because of the coming together of people with exceptional experience and expertise. Dr Shome has brought in extraordinary perspective in terms of his own rich experience in tax administration and laws, as well the practices around the world that we can adopt in India. The report is also practical because of the active participation of two former chairmen, and two former members of CBEC and CBDT, apart from representatives like me and MR Diwakar from the private sector.

S Mahalingam is an Independent Director on the Board of Kasturi & Sons, the publishers of

BusinessLine

Don't Weaken the Reserve Bank

Both finance minister Arun Jaitley as well as RBI Governor Raghuram Rajan have done well to contain the controversy created by amendments to the RBI Act proposed by the Finance Bill. Innocuous sounding changes to Sections 45 U and W of the RBI Act make it difficult for the central bank to conduct repo and reverse repo operations, critical for ensuring appropriate liquidity in the system—that is the only way the central bank can ensure the overnight rate is as close to the repo as possible. When analysts figured out the import of the Finance Act changes and brought it to Rajan’s notice, he simply said since the move didn’t find mention in the finance minister’s Budget speech—where all significant policy statements find mention—he was confident the government would not be implementing the changes. And when Jaitley was quizzed about this, he simply said that the matter would be discussed in Parliament, suggesting it would be fixed by way of an amendment to the Finance Bill. Given it could not possibly have been the government’s intention to stymie the RBI’s functioning, it is apparent the changes were not fully thought through and will be fixed now.

The other area where there is some disquiet that needs addressing relates to the formation of the monetary policy committee (MPC) which is part of the agreement between the government and RBI on inflation-targeting. While this newspaper has argued against inflation targeting given that it leads to a permanently higher level of interest rates—primarily because items like food which comprise the lion’s share of CPI do not respond to monetary policy—it is important to preserve the primacy of the central bank. More so since, after inflation-targeting is now a formal policy, the central bank will be held accountable for keeping inflation under check. There is, at present, a tussle on what model of the MPC is to be adopted. Under the one proposed by the Urjit Patel committee—Patel is RBI Deputy Governor—the MPC would comprise 5 members, all of whom would either be from RBI or nominated by RBI. The RBI Governor, Deputy Governor and ED in charge of monetary policy would be members and the other two would be chosen by the first two; apart from this, the RBI Governor would have the casting vote in case one member is absent. In the MPC proposed by the FSLRC, there would be 2 RBI members and 5 external ones. Of the external ones, 2 would be appointed in consultation with RBI and 3 others solely by the government. While the RBI Governor would have the power of veto in the FSLRC model, this would be under extreme circumstances and would have to be accompanied by a written explanation. In other words, the FSLRC model of the MPC has the balance of advantage with the government, which is not a happy situation since the idea is to have an independent central bank, not one which is a rubber stamp for the government. Since the public perception of the central bank’s independence is an important component of how market players view the bank, the government would do well to accept the Urjit Patel formulation.
(Published in FinancialExpress.com )

The agreement on monetary policy framework

Monetary Policy Framework: It takes two to tango
March 4, 2015, 7:15 AM IST Economic Times in ET Commentary | Economy | ET
By Madan Sabnavis

The agreement on monetary policy framework signed by the government and Reserve Bank of India (RBI) is significant because this is the first time such a thing has been done. Curiously, this was a recommendation of the internal committee set up by RBI earlier, and, hence, is not coming from the top but is an internally agreed-upon move. The RBI has already been targeting CPI inflation; the difference is that it will be responsible for the inflation number. This is the addition to the storyline. It is extremely interesting to watch how this will play out, for four reasons.

First, the RBI will be targeting the CPI inflation number whose composition is such that its own policy may have limited power to influence. The new index, with 2012 as base, assigns weights of 48.3% to food-related items, 10.1% to housing and 6.8% to fuel and light, which are not leveraged. This accounts for around 65% of the index. Clothing, with a weight of 6.5%, may be leveraged through cards and another 3-4% of the miscellaneous category (weight of 28.35) which includes handsets, television, refrigerators, could be on credit. Therefore, not more than 10% of the index, which is being targeted, could be amenable to monetary policy action.

Further, in FY14 for instance, the items outside the RBI’s purview accounted for over 98% of inflation. While interest rate action should be linked to inflation on grounds of prudence to ensure positive real interest rates, expecting the repo rate to control inflation which is largely driven by supplies, government action (crude oil and related products) and extraneous forces is a challenge.

Second, there is sound reason for having a target of 4% with a band of 2% at either end. However, an economy which has not invested much in agriculture will always be susceptible to supply shocks from farm products. In the past 10 years, we have had CPI inflation for industrial workers at less than 6% only twice, and, in fact, in the past eight years it has always been higher than 6%. Are we challenging ourselves considering that 4% looks like a tall order?

Third, the inflation targeting has to be done while also ‘keeping in mind the objective of economic growth’. This poses a conundrum. Going by, say the old GDP series, when growth had slowed down to 4.5% and 4.7% in FY13 and FY14, respectively, which coincided with CPI inflation numbers of 10.2% and 9.5%, would the monetary authority have been expected to keep increasing rates continuously or just retain rates at
high levels? It would never have been possible to explain why monetary policy could not bring down inflation especially since products like tomatoes and onions pushed up inflation, over which monetary policy has no control.

Fourth, the RBI has often commented on the policy transmission mechanism being weak. Therefore, when the RBI lowers or increases rates by 50 bps, the response in bank deposit and lending rates is not proportional. The repo rate affects them to the extent of say 1% of NDTL which is around `80-85,000 crore, which is accessed through the daily LAF and term repo facilities. Would this then mean the RBI has to lower the LAF facility in case it realises banks are not increasing rates when the repo rate is increased? It is because of this sluggish mechanism that there are dualistic images in the market — an increase in repo rate leads to G-sec yields increasing even while banks may not be doing so with their rates. An interesting conjecture to make is on the response time for policy action in future. If inflation goes up to say 6.2% for February, would this mean the trigger will be
pulled even before the policy? The market will start guessing more on the 12th of every month when the CPI numbers are released and that will add zing to an otherwise sedentary money market.

(Published in EconomicTimes.com)

Payment Banks: Will They Work Here?

The rush for licences notwithstanding, there are serious questions regarding their viability

in a country like India Raghu Mohan

        You will soon get to see a new bank in your neighbourhood. It will accept deposits, remit money, hawk third-party products and services, and issue debit cards. But you will not get a dime as credit. The new beast is a payments bank. Now why on earth should you bank with one? We are told that’s the whole idea behind it — it’s not meant for folks who are already part of the banking universe or think of it the way they are accustomed to. Touted as the best on offer after sliced bread, payment banks are meant to bolster financial inclusion so that the multitudes who fall outside the pale of banking (not seen as ‘bankable’) — only around 60 per cent of the country’s 1.2 billion people are covered by banks — can be brought within its ambit. Nearly 43 per cent of rural households relied on informal credit when the last All-India Debt and Investment Survey was undertaken in 2002. While the population per bank branch has come down to 12,300 from 64,000 in 1969 (when such data began to be tracked), Basic Statistical Returns showed that rural India had only seven branches per 1,00,000 people in 2011 (the latest figures in the public domain); most developed economies have over 40 branches. Payments is big business. Crisil Research puts the domestic remittance market at Rs 800-900 billion and expects it to grow at 11-13 per cent (CAGR) over the next few years. It needs to be mentioned here that the ratings agency has restricted the remittances’ turf to low-income migrants who are seen as early adopters of payments bank services. Non-banking financial companies, telcos, retail giants — even existing banks — can aspire to a payments bank licence from Mint Road. Telcos (current share 3-4 per cent of remittances) will snatch business away from an India Post or informal sources on account of superior reach (especially in rural areas) and lower cost of transaction; by fiscal 2019, their share is seen growing to nearly 15 per cent.

Little wonder then that nearly 40 applicants have queued up at Mint Road for a payments bank licence; they include Reliance Industries (with State Bank of India), Aditya Birla Group (Idea), Bharti Airtel (with Kotak Mahindra Bank or KMB) and Vodapone (with Yes Bank) and business correspondents (BC) like Oxigen. A retailer, Future Group, is also in the race. If you look at the 70-odd applicants who have sought a small bank licence (full service, but with small ticket sizes), it’s clear that bottom-of-the-pyramid banking is seen as an El Dorado. Says Manish Khera, co-founder of FINO, a small-bank licence applicant and a BC: “There are scores out there who are not seen as bankable even by today’s small banks. The approach of most of them, too, has changed; it is like that of the bigger banks. They are not keen on the bottom of the pyramid.” Just how big is the scale of his ambitions? “Five years from now, I hope to have an asset size of Rs 2,500 crore,” he says. That’s the kind of bulk a medium-size bank puts on in

two months!

       According to Monish Shah, senior director at Deloitte (India), “The approach of payment banks is to create supplementary access points from a customer’s perspective and this new supply of financial services will, hopefully, meet the unmet demand of providing banking at the doorstep.” What’s unsaid in all this is that any kind of banking licence from Mint Road can be a force multiplier for your branding and reputation. The irony is if payment banks do increase the ‘touch points’ to serve the needy, their very success has the potential to eat into many a weak commercial bank’s traditional deposit and payments business. And if that were not to happen, the question that arises is: what becomes of payment banks at the end of the day? Says Ravi Rajagopalan, CEO, Empays Payment Systems: “To the extent that all banks offer current and saving accounts (CASA), these (paymentbanks) are me-too in nature.” Yet just about everybody has jumped onto the bandwagon. Last September, when asked how many such banks will be issued licences, Reserve Bank of India governor Raghuram Rajan said: “I don’t have a number… my guess is, and this is just a guess, that it will be certainly more than two and I don’t want to put an upper limit, I don’t want to put a lower limit, other than saying that the lower limit will not be two... We need to ensure that there are a variety of participants that are licensed here so that we can learn from the experience. That would imply a reasonable number.”

          Now your ubiquitous bank and its watered-down avatar cannot both laugh their way to the bank, although it needs to be said here that we are now in unfamiliar territory — nobody quite knows how the underfoot conditions in the park will play out.

Sound On Paper

         A payment bank has been conceived as a ‘scaled up’ version of a pre-paid instrument (PPI) player — an entity that accepts cash (‘deposits’) and tucks it into a ‘digital’ or ‘plastic’ wallet. The sums (aggregate) ‘raised’ by PPIs are parked in escrow accounts with banks (so that they are not diverted to ‘treasury play’) and earn no interest. Nor can PPIs pay interest to ‘depositors’ — now that’s a huge fault line as the sums are substantial relative to the savings of low-income households which are sought to be brought under the umbrella of financial inclusion. So PPIs can morph into payment banks. The well-heeled may also troop in. Nielsen (India) in a study (it reached out to high, mid- as well as low-income consumers, between 22 and 60 years of age, who influence decision-making in households) says a majority have few, if any, existing investments and show little inclination to invest over the next 12 months. This segment’s financial requirements are mostly confined to basic banking transactions like deposits, withdrawals and fund transfers. A resounding 72 per cent of respondents — low, mid- and high-income — said they would consider opening an account with a payment bank, with equal preference shown for retail and telecom players. While the response of low-income consumers comes as no surprise given that they are largely underserved by banks, those of mid- and high-income respondents is a bit of a surprise and come as a shot in the arm for payment banks.

       “In what may be of concern to banks, mid- and high-income consumers have cited the convenience of fewer trips to banks as the main attraction of payment banks. Younger consumers are more willing to open payment bank accounts because of convenience,” says Anand Parameswaran, director, Nielsen (India). Adds Rajagopalan: “A very large proportion of accounts are of less than Rs 1 lakh in value – this is the bulk of Indian CASA. These can migrate to new payment banks. Competition is expected to improve service, better the return and cut the cost of operations for the banking system as a whole. This is the intent of the legislation.”

         A closer reading of what Parmeswaran and Rajagopalan’s views makes a few things clear: one, there is a universe which is laid-back, but has a cash surplus; and two, many with less than a lakh in the bank will move to a payment bank. On paper, payment banks will fire.

But Look At The Math

        A payments bank can accept deposits up to Rs 1 lakh from a customer (the limit may be revised upwards, but that’s in the future). To deposit a higher amount, you either have to go to another bank of its ilk or a ‘regular’ bank. Now, it’s a no brainer that a payment bank must offer rates that are competitive. Recall that CASA (the more you have of them, the lower the cost of funds), is not exactly ‘cheap’. There is a cost to acquiring them other than the interest rate offered — branches and manpower, among others. That’s why it is the smaller banks such as Kotak Mahindra Bank (KMB), Yes Bank and IndusInd Bank that offer the best rates. But this game can be played only up to a point: when the share of CASA vis-a-vis total deposits is lower than that of peers. And while you do so, you have to be smart. Take KMB: its deposits grew 15.8 per cent to Rs 59,072.3 crore in end-March 2013; savings’ bank (SB) deposits rose 38.8 per cent to Rs 10,087.1 crore. But it may surprise you to know that while the bank offers 6 per cent on its SB accounts, its average cost for this mop-up stands at 5.5 per cent! If a payments bank cannot lend, has to maintain a cash reserve ratio (CRR), a statutory liquidity ratio (SLR) and invest its deposits only in government securities (which offer returns of about 6-7 per cent), how is it to make enough to cough up for its operations and pay interest on deposits? Let’s also not lose sight of the fact that a payments bank has to compete with credit co operatives (which cater to small and marginal farmers) which expand into urban cooperative banks; regional rural banks which incorporate features of co-ops and banks. And all of them offer credit too. If you are keen on numbers, here you go: we have 26 state-run; 20 private (seven new, 14 old); 43 foreign banks; 64 regional rural banks; 1,606 urban cooperative banks and 93,551 rural co-ops — all of them chasing customers.

         That’s why Crisil points out that even though telcos are likely to capture around 15 per cent of the domestic remittances market, luring deposits is another ball game altogether because they will have to invest in brand building and gain the trust of depositors (just paying competitive interest rates will not do). “As a result, we forecast payment banks having a minuscule share of less than 0.5 per cent of CASA deposits of the Indian banking system five years after launch,” says Ajay Srinivasan, director, Crisil Research. In defence of payment banks, Swarup Roy Choudhury, managing director of First Data, says: “It is not a brick-and-mortar model. The cost structure is not like that of a commercial bank.” What if a commercial bank were to set up one of its own? “I don’t know how they (banks) will distinguish it from what they already offer their customers. You can’t (as a bank) just strip the entire payments business and push it into a new payments bank.” He stresses on cross-selling. “What matters is that you have a relationship with your customer on the credit side; it does not matter whether you `manufacture’ a financial product.” You can’t argue with that. IndusInd Bank ‘sells’ home loans of HDFC Ltd; HDFC Bank also hawks those of its parent; and ICICI Bank vends AmEx cards; banks sell insurance products of their own and those of rivals. The point being made here is that as long as you can buy what you want to from a counter, it does not matter whose counter it is. At least that’s how the argument goes. But making cross-selling work is a different proposition; few have succeeded in pulling it off. The cross-sell ratio (relationships per customer) for the best of the lot will at best be a shade above three (there are no industry-level studies as yet). The global leader, Wells Fargo, claims in excess of six. You can’t expect payment banks to beat legacy banks straightaway on cross-sell.

        Let’s look at the fee income potential for payments banks. The offerings (third-party) will perforce have to be tailor-made for clients. It’s a hurdle that even the best of commercial banks have not overcome in their efforts to get into lower-tier cities. So it’s a tough ask to expect them to customise offerings for payment bank customers. Then again, the credit appraisal in such cases is done by the bank whose product is being cross-sold. And,what stops commercial banks from playing the same game? They too can cross-sell a suite of services to their depositors (whatever the size of deposits) and offer them better pricing if they consolidate their relationship (with a bank) — discounts on car, home and personal loans. The coming of age of credit bureaus, data mining and analytics will hasten this process. Axis Bank has made sure existing depositors drive 60 per cent of its incremental retail assets. Of course, you have to make sure as a bank that your liability and assets businesses ‘talk to each other’ to increase cross-sell and not be silo-ed. Few state-run banks do so (which account for 72 per cent of market share), but Out Of Context?

    

    The case for a PPI to convert to a bank was valid as in case the bank in which the escrow was held went belly up, it could take the PPI with it — the amounts held by the PPI have no deposit insurance unlike the direct depositors of the bank. The Nachiket Mor Committee on Comprehensive Financial Services for Small Businesses and Low Income Households observed: “All `nested’ have this feature and there may be greater stability obtained from independent designs where the PPI deals directly with RBI rather than through a sponsor bank.” PPIs like Airtel Money and Oxigen are ‘nested’. The idea of a payments bank is not new. Brazil’s (Law 12865) created a new legal entity known as a ‘payments institution’, to be regulated by the Brazilian Central Bank; in 2007, the South African Reserve Bank said non-bank payment service providers (PSP) can play an important role in the payments system. And, globally, in the inclusion context, Kenya‘s M-Pesa is the most successful ‘nested’ payments bank. Over two-thirds of Kenyans use this service and about 25 per cent of the country’s GDP flows through it. But the Indian version is an ‘independent payments bank’ which would be a direct participant in the payments system and, instead of escrow balances with a sponsor bank, hold reserves — CRR and SLR — with Mint Road.

        These examples cannot be stretched to make a case for payment banks. “We do not expect payment banks to repeat that success in India. Rather, the value of transactions through payment banks is likely to be less than 0.2 per cent of India’s GDP by fiscal 2019,” says Srinivasan. His view is that the M-Pesa service in Kenya benefited from lower banking penetration (less than 15 per cent at the time of launch in 2007), higher working migrant population and regulatory patronage (telcos in the country do not require tie-ups with banks). Safaricom was able to navigate KYC concerns as Kenya has a national identification system. “Compare that with India where users need basic identification to open ‘accounts’ and must go through some due diligence, which reduces adoption. Also, competition from other modes of money transfer (postal system, etc.) is significant unlike in Kenya where remitting money through people (which can be unsafe) was the predominant mode of money transfer prior to M-Pesa,” says Srinivasan.

Yet some telcos may pull it off. That’s because, compared to them, an India Post, a large BC, PPIs and retail chains will be at a disadvantage as their customer base is limited. They will have to make significant investments on expanding their distribution network, technology and brand-building. The business will make losses for at least a few years (till volumes pick up), as spreads earned on deposits and earnings from remittances may not be sufficient to cover distribution, marketing and technology costs.

       The key driver for telcos is that they can increase the ‘stickiness’ of their customers. That means a lower churn rate which, over a period of time, could lead to an increase in average revenue per user (ARPU) which is in the region of Rs 119 per month. Another plus is the commission telcos can earn on transactions — big telcos have well over 100 million subscribers; even if each one of them conducts one transaction a month, it translates into 1.2 billion transactions annually. The value of transactions through m-wallet have more than trebled in the past two years to over Rs 27 billion in the last fiscal, indicating the huge business potential. The additional channel of income for them as payments banks is deposits (difference in yield earned by investing deposits and the interest rate offered on deposits). Crisil feels it will hasten the EBITDA break-even period by 2-3 years compared to plain vanilla m-wallet services. They can also save on commissions currently paid to a bank whenever a customer withdraws cash (technically called cash-out), but then telcos will have to take care of cash management on their own (which can be a challenge). Former RBI deputy governor K.C. Chakrabarty is on record stating that “my only question about payment banks is what will be their viability? How will they earn money?” He said financial inclusion was not limited to merely opening bank accounts. “Financial inclusion is also providing emergency credit. The maximum request from the poor is for emergency credit.”

Given the number of applicants for both payment banks and small finance banks, it is possible that Mint Road may go in for an ‘on-tap’ approach while issuing licences — dole them out as and when they are seen as fit, proper and needed (and not unlike the method adopted for new private bank licences). You might well see the first of this lot a year down the line. We are well on our way to ‘tap’ and ‘pay’. With inputs from Anup Jayaram

(This story was published in BW | Business world Issue Dated 09-03-2015)

The new participatory note regime

The new participatory note regime: How will the market react?

February 9, 2015, 4:43 PM IST Economic Times in ET Commentary | Business, India, Markets | ET

The Securities Exchange Board of India’s latest circular on overseas direct investment (‘ODI’) / participatory notes (‘P-notes’) marks another step by the Indian Government to curb money laundering by imposing tight norms for foreign investors accessing Indian markets. P-notes have always been a preferred option for overseas investors who want to have easy access to Indian markets without formally being compliant with Indian regulations. P-notes help them avoid time, cost and procedural issues associated with SEBI registration, making investment simple and attractive. Given this fact, the current regulations have resulted in rules that may not be welcomed by many P-notes investors. markets-up-bccl

This article summarises the changes brought by the regulations and issues that may arise for both P-note participants as well as P-note issuers.

1. Narrowed the set of countries for P-note participants – They have to be compliant with both IOSCO and FATF, which is the

anti-money laundering international body. Furthermore, they cannot be issued to opaque structures

2. Investors caught on both the legs –The investment restrictions imposed are like double edged sword. They not only consider

two P-note holders having a common beneficial owner as one holder, but also consider clubs’ P-note holdings with foreign

portfolio investors (‘FPI’) for calculating investment limits.

3. Investment restrictions resulting in switching from one FPI to another- FPI and positions held as P-notes will now be clubbed together for meeting the investment criteria of 10% per FPI. This would mean that P-note holders whose current holding after clubbing with FPI has exceeded 10% will now have to unwind their investment to meet the norms or else they will have to move to another FPI which has the bandwidth to accommodate them. This also means FPIs will now have to keep a tab on their investment limits and may also have to stop if the norms are crossed. From a P-notes perspective, every time an investor wish to invest, they will first have to check whether the FPI has the bandwidth to accommodate them, or else they will have to search for another FPI. Investors have always been attracted to P-notes only for their ease in accessibility and this move hampers this

completely.

4. The burden of disclosures – The onus of ensuring compliance by P-notes is on the FPIs, which in turn implies that they may resort to taking necessary undertakings / disclosures, etc. from the investors or follow certain other procedures . This may work in the same manner as the way FPIs discloses information to their designated depository participants (‘DDP’). This is a big

hindrance as P-notes participants always wanted to do away with disclosure norms.

5. Ambiguity on disclosure requirements – In a situation where two ODIs have common a beneficial owner and have to club for investment restrictions, it is not clear where they would report the

disclosure requirements. FPIs have DDP in place to report their disclosures to, but P-note holders do not have DDP and hence, clarity is required in this connection. The above move of SEBI comes at a time where the domestic market is experiencing a steady rise in P-notes since July. The value of outstanding investments in P-notes into India’s capital market stood at 2.66 trillion at the end of October, the seventh highest level in almost seven years. The budget speech of Honorable Finance Minister early this year laid out two objectives of the Indian Government i.e. liberalising regulatory norms for foreign investors in order to boost foreign investment in India and the curbing of black money from flowing in the economy . This move of SEBI aligns with its second objective; however the boosting of foreign investment may not fully materialise with the current regulations. We believe that the government needs to take a balanced approach in handling the foreign investors so that the inflow of foreign capital is not obstructed and at the same time there is no misuse of such structures for round tripping and money laundering.

(The authors are Partner, PwC India and Senior Manager, PwC India, respectively.)

Rural Credits and RBI

Revisiting rural indebtedness- Rural Credits

The problem in rural India is not one of too much credit to poor households that leads to debt waivers that damage bank balance sheets, but one of inadequate access to credit from formal sources.

IF Reserve Bank of India Governor Raghuram Rajan is to be believed, efforts to help Indian farmers by providing them with cheap(er) credit and relieving them of an unsustainable debt burden only harms them in the long run. In his speech delivered at the annual

conference of the Indian Economic Association, Rajan is reported to have advanced a number of counterintuitive arguments and raised a number of unusual questions on farm debt. The first was that when governments in the States or at the Centre intervene in periods of distress (resulting from damage due to floods, cyclones or drought, for example) by requiring banks to waive farm debt with promise of official support, they end up restricting

credit flow to agriculture. Banks become reluctant to lend to farmers because they fear that those new loans too would be written off. Moreover, as happened with loans that were written off when governments in Telangana and Andhra Pradesh declared loan waivers

when cyclone Phailin ravaged the region last year, the promise of official support may not be kept. While the Telangana government did deliver the mandated 25 per cent of the loan amount written off by the banks, Andhra Pradesh has thus far not done so. This, in the

governor’s view, would only increase the reticence of the banks to lend. Clearly in his view, the government cannot influence the behaviour of even banks that are publicly owned, even though it seems to be able to force them to lend huge amounts to privately operated infrastructure projects in areas varying from power to civil aviation.

Second, there is, according to the governor, reason to believe that when debt waiver schemes are implemented they are afflicted by significant errors of inclusion and exclusion, providing benefits to those who are not eligible and bypassing some who should be benefited. To illustrate this view, he refers to the Comptroller and Auditor General (CAG) report that found that in 2008 when the United Progressive Alliance (UPA) government implemented an Agricultural Debt Waiver and Debt Relief Scheme, which provided debt relief to the tune of Rs.52,516 crore, there were several instances when ineligible farmers were given the benefit and eligible ones were ignored. Suggesting that this evidence pointed to the possibility of fraud, the governor has argued against such schemes. The strategy seems to be one of avoiding the possibility of fraud rather than one of detecting and penalising fraud.

Finally, the governor argued that cheap and subsidised credit to the farm sector in the form of short-term crop loans rather than longterm loans for investment may be diverting credit away from capital formation with attendant adverse consequences for productivity, even while the indebtedness of farmers increases. The thrust of these arguments seems to be that the policy adopted after bank nationalisation, of directing credit to the priority sectors

at reasonable interest rates, with 18 per cent of total advances mandated to be provided to the agricultural sector, should be revisited. It may be better to leave it to banks to decide whether credit should be provided to the agricultural sector, and if so to which activities

and at what interest rate. Implicit in that view is the perception that forced lending to agriculture has not only resulted in a sharp expansion of credit to the farm sector, but also in indebtedness of a kind that demands periodic debt waiver and relief schemes at the

expense of bank balance sheets and productive investment.

This amounts to turning hitherto received wisdom on its head. The policy of directing credit to agriculture was adopted because evidence on the eve of bank nationalisation pointed to the near-complete exclusion of agriculture from bank credit. Despite accounting

for as much as a third of the gross domestic product (GDP) and more than two-thirds of total employment in the mid-1960s, agriculture received around 2 per cent of total bank credit advanced. Nationalisation was seen as breaking the control of the businessgroups over much of the banking system which was seen as explaining this exclusion of agriculture from bank credit flows, which went largely to the corporate sector. It was also seen as creating conditions that ensured that it was not just profit but the development

objectives of the government that were served by the banking system.

The evidence shows that with public ownership, the target of directing 40 per cent of total credit to the priority sectors and the subtarget of channelling 18 per cent of total credit to agriculture were soon achieved. The change in ownership had clearly transformed

bank behaviour to yield the intended result. Yet, in 1991, the first Narasimham Committee on the Financial System recommended that the directed credit programme should be phased out, the “priority sector” redefined and its share in total credit reduced from 40 to not more than 10 per cent. The justification provided was largely that the directed credited programme was adversely affecting profitability and contributing disproportionately to the non-performing assets of the banking sector. Even though this recommendation of the Narasimham Committee was not accepted by the Reserve Bank of India and the government, liberalisation of the bank licensing policy after 1991 saw a reduction in the number of rural branches and a decline in the share of commercial banks in outstanding agricultural credit from about 61 per cent of total agricultural credit in 1990-91 to around 26 per cent in 1999-2000. Reform seemed to have encouraged banks to withdraw from the direction pursued until then.

Interestingly, after 2004 the trend changed sharply with the share of commercial banks in agricultural credit rising once again to reach 58 per cent by 2010-11. However, as Pallavi Chavan has underlined, there was one major difference in the trends in bank credit to

agriculture in the years prior to and after 2004. In the period between 1973-74 and 1997-98, while the ratio of agricultural credit to agricultural GDP rose from around 10 to around 25 per cent, the ratio of capital formation in agriculture to agricultural GDP also rose

from around 6.5 per cent to 8 per cent of GDP. While the divergence between the two ratios had increased, the increase in credit was also supporting increased investments in agriculture. However, starting from the end of the 1990s, while the ratio of agricultural credit to agricultural GDP shot up from around 25 per cent to about 73 per cent by 2010-11, the ratio of capital formation in agriculture to agricultural GDP rose only from around 8 to 17 per cent. This huge increase in divergence implied that far more money was going to

non-productive purposes. This was also a period when agricultural GDP was rising at a slow 2.8 per cent per annum. The boom in bank credit to agriculture was contributing only marginally to capital formation and growth. 

One reason is because, as suggested by the Narasimham Committee, the notion of priority sector credit was redefined, with new areas such as lending to input providers (such as seed suppliers), warehouses and microfinance institutions being treated as “indirect finance”

to agriculture. Even though indirect finance to agriculture could only amount to 25 per cent of the agricultural lending sub-target of 18 per cent (or 4.5 per cent of total advances), any such lending in excess of 4.5 per cent could be included when computing achievement

of the 40 per cent aggregate priority sector requirement. This opened a set of relatively lucrative lending avenues that could serve to meet the priority sector lending target. According to Pallavi Chavan, “the share of indirect credit in total agricultural credit more than doubled from 21.5 per cent in 1991-92 to 48.1 per cent by 2007-08”. Thus, if there is any distortion in the distribution of agricultural credit, it seems to result from the liberalisation of policy rather than from excessive intervention.

What is also remarkable is that despite the boom in bank credit to agriculture, the access to credit in the rural areas still remains limited. According to the recently released results of the All India Debt and Investment Survey conducted by the National Sample Survey Organisation, as on June 30, 2012, there were only 31.4 per cent of households in rural India that were exposed to debt. That was not very much higher than the 26.5 per cent recorded in the previous survey relating to 2002. Moreover, 19 per cent of the rural households obtained credit from non-institutional sources and only 17 per cent from institutional sources (including banks). Clearly, the perception that rural households have been forced into excess indebtedness because of availability of cheap bank credit seems to be overstated.

What is more, an analysis of the class-wise distribution of the incidence of indebtedness shows that while the incidence varied between 19.7 and 27.5 per cent in the lowest four deciles classified in terms of the size of asset holding, the average debt of each of the

households in these deciles varied from just Rs.40,000 to Rs.50,000. On the other hand, the incidence of debt in households in the richest decile in terms of assets was 41.3 per cent, with the average debt of indebted households placed at Rs.2.7 lakh. Not surprisingly,

while the percentage of households indebted to institutional sources was placed at 7.9 and 7.4 per cent respectively in the poorest asset classes, the figure stood at 32.6 for the richest asset class. On the other hand, in terms of exposure to non-institutional debt, the figures

were 14 and 17 per cent in the poorest asset classes and 15.3 per cent in the richest. Poorer households were being forced to rely disproportionately on non-institutional sources for credit. In sum, what the evidence seems to suggest is that the problem in rural India is not one of too much credit to poor households that leads to debt waiver schemes that damage bank balance sheets, but that of inadequate access to credit from formal sources. If rural

credit needs to be revisited, it must be to expand credit access rather than to restrict it because of excessive indebtedness. Moreover, it appears that when banks are given greater freedom, they lend far less for capital formation rather than much more. And the size of

the loans involved is clearly small change when compared with the loans handed out to those in the corporate sector who are increasingly being seen as wilful defaulters. As the governor has flagged on another occasion, those large wilful defaulters see the

restructuring of debt which they have stopped servicing as their right rather than (as ostensibly in the case of debt waiver schemes) a favour from the government or the Reserve Bank of India.

(Published in Frontline.in)